**U.S. SECURITIES AND EXCHANGE COMMISSION**

 

**WASHINGTON, D.C. 20549**

 

**FORM 10-QSB**

 

**QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended March 31, 2003Commission File Number: 0-15982**

 

| **NATIONAL MERCANTILE  BANCORP**                                        |
|-------------------------------------------------------------------------|
| (Exact name of small business issuer as  specified in its charter)      |
|                                                                    |   |   |
| **California**                                                          |   | **95-3819685** |
| (State or other jurisdiction of  incorporation or organization)         |   | (I.R.S. Employer  Identification No.) |
|                                                                    |   |   |
| **1840 Century Park East, Los Angeles,  California**                    |   | **90067** |
| (Address of principal executive offices)                                |   | (Zip Code) |
|                                                                    |   |   |
| Issuer’s telephone number, including area  code **(310) 277-2265** |

 

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

 

| YES | ý |   | NO | o |
|-----|--------|--------|----|---|

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

 

The number of sharesoutstanding of the issuer’s Common Stock, no par value, as of May 10, 2003 was2,692,729.

 

 

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PART I – FINANCIAL INFORMATION

 

*Item 1. Financial Statements*

 

**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

(Unaudited)

 
|                                                                                                                                                                                           |   | **March 31,  2003**        |    | **December 31,  2002** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------|---------|------------------------|--------|
|                                                                                                                                                                                           |   | **(Dollars in thousands)** |    |
|                                                                                                                                                                                           |   |                       |    |                   |   |
| ASSETS                                                                                                                                                                                         |   |                       |    |                   |   |
| Cash and due from banks-demand                                                                                                                                                                 |   | $                          | 18,039  |                   | $      | 18,876 |   |
| Federal funds sold and securities purchased under agreements to resell                                                                                                                         |   | 31,400                     |    | 18,700                 |   |
| Cash and cash equivalents                                                                                                                                                                      |   | 49,439                     |    | 37,576                 |   |
| Securities available-for-sale, at fair value;  aggregate amortized cost of $17,834 and $25,824 at March 31, 2003 and  December 31, 2002, respectively                                          |   | 17,992                     |    | 26,170                 |   |
| Due from banks-time                                                                                                                                                                            |   | 325                        |    | 325                    |   |
| FRB and other stock, at cost                                                                                                                                                                   |   | 2,018                      |    | 2,018                  |   |
|                                                                                                                                                                                           |   |                       |    |                   |   |
| Loans receivable                                                                                                                                                                               |   | 267,746                    |    | 272,323                |   |
| Allowance for credit losses                                                                                                                                                                    |   | (4,694                     | )       | (4,846                 | )      |
| Net loans receivable                                                                                                                                                                           |   | 263,052                    |    | 267,477                |   |
|                                                                                                                                                                                           |   |                       |    |                   |   |
| Premises and equipment, net                                                                                                                                                                    |   | 5,731                      |    | 5,836                  |   |
| Other real estate owned                                                                                                                                                                        |   | 1,535                      |    | 1,000                  |   |
| Deferred tax asset                                                                                                                                                                             |   | 7,876                      |    | 7,984                  |   |
| Goodwill                                                                                                                                                                                       |   | 2,174                      |    | 2,174                  |   |
| Core deposit intangibles, net                                                                                                                                                                  |   | 2,021                      |    | 2,077                  |   |
| Accrued interest receivable and other assets                                                                                                                                                   |   | 5,211                      |    | 2,748                  |   |
| Total assets                                                                                                                                                                                   |   | $                          | 357,374 |                   | $      | 355,385 |   |
|                                                                                                                                                                                           |   |                       |    |                   |   |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                                                                                      |   |                       |    |                   |   |
| Deposits:                                                                                                                                                                                      |   |                       |    |                   |   |
| Noninterest-bearing demand                                                                                                                                                                     |   | $                          | 114,171 |                   | $      | 107,580 |   |
| Interest-bearing demand                                                                                                                                                                        |   | 27,116                     |    | 30,465                 |   |
| Money market                                                                                                                                                                                   |   | 47,133                     |    | 43,134                 |   |
| Savings                                                                                                                                                                                        |   | 46,283                     |    | 42,182                 |   |
| Time certificates of deposit:                                                                                                                                                                  |   |                       |    |                   |   |
| $100,000 or more                                                                                                                                                                               |   | 36,844                     |    | 43,006                 |   |
| Under $100,000                                                                                                                                                                                 |   | 31,039                     |    | 32,358                 |   |
| Total deposits                                                                                                                                                                                 |   | 302,586                    |    | 298,725                |   |
|                                                                                                                                                                                           |   |                       |    |                   |   |
| Federal funds purchased and securities sold under agreements to  repurchase                                                                                                                    |   | 792                        |    | 1,476                  |   |
| Other borrowings                                                                                                                                                                               |   | 7,500                      |    | 7,500                  |   |
| Accrued interest payable and other liabilities.                                                                                                                                                |   | 736                        |    | 1,950                  |   |
| Total liabilities                                                                                                                                                                              |   | 311,614                    |    | 309,651                |   |
|                                                                                                                                                                                           |   |                       |    |                   |   |
| Guaranteed preferred beneficial interests in the Company’s junior  subordinated deferrable interest debentures, net                                                                       |   | 14,534                     |    | 14,530                 |   |
|                                                                                                                                                                                           |   |                       |    |                   |   |
| Shareholders’ equity:                                                                                                                                                                     |   |                       |    |                   |   |
| Preferred stock, no par value - authorized 1,000,000 shares:                                                                                                                                   |   |                       |    |                   |   |
| Series A non-cumulative convertible perpetual preferred stock;  authorized 990,000 shares; outstanding 732,785 shares and 734,985 shares at  March 31, 2003 and December 31 2002, respectively |   | 5,985                      |    | 6,003                  |   |
| Series B non-cumulative convertible perpetual preferred stock;  authorized 1,000 shares; outstanding 1,000 shares                                                                              |   | 1,000                      |    | 1,000                  |   |
| Common stock, no par value; authorized 10,000,000 shares; outstanding  2,679,729 and 2,679,544  shares at  March 31, 2003 and December 31, 2002, respectively                             |   | 38,105                     |    | 38,054                 |   |
| Accumulated deficit                                                                                                                                                                            |   | (13,956                    | )       | (14,055                | )      |
| Accumulated other comprehensive income                                                                                                                                                         |   | 92                         |    | 202                    |   |
| Total shareholders’ equity                                                                                                                                                                |   | 31,226                     |    | 31,204                 |   |
| Total liabilities and shareholders’ equity                                                                                                                                                |   | $                          | 357,374 |                   | $      | 355,385 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

2

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**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

(Unaudited)

 
|                                                                                                                                                              |   | **For the  Three Months Ended  March 31,**          |       |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------|------------|
|                                                                                                                                                              |   | **2003**                                            |       | **2002** |   |
|                                                                                                                                                              |   | **(Dollars  in thousands,  except per share data)** |       |
|                                                                                                                                                              |   |                                                | ** ** |   | ** ** |
| Interest income:                                                                                                                                                  |   |                                                | ** ** |   | ** ** |
| Loans, including fees                                                                                                                                             |   | $                                                   | 4,117      |   | $ | 4,391 |   |
| Securities available-for-sale                                                                                                                                     |   | 250                                                 |       | 483 |   |
| Federal funds sold and securities purchased under agreements to resell                                                                                            |   | 43                                                  |       | 127 |   |
| Total interest income                                                                                                                                             |   | 4,410                                               |       | 5,001 |   |
| Interest expense:                                                                                                                                                 |   |                                                |       |   |   |
| Interest-bearing demand                                                                                                                                           |   | 61                                                  |       | 72 |   |
| Money market and savings                                                                                                                                          |   | 301                                                 |       | 328 |   |
| Time certificates of deposit:                                                                                                                                     |   |                                                |       |   |   |
| $100,000 or more                                                                                                                                                  |   | 147                                                 |       | 307 |   |
| Under $100,000                                                                                                                                                    |   | 282                                                 |       | 405 |   |
| Total interest expense on deposits                                                                                                                                |   | 791                                                 |       | 1,112 |   |
| Federal funds purchased and securities sold under agreements to  repurchase                                                                                       |   | 8                                                   |       | 37 |   |
| Other borrowings                                                                                                                                                  |   | 89                                                  |       | 150 |   |
| Total interest expense                                                                                                                                            |   | 888                                                 |       | 1,299 |   |
| Net interest income before provision for credit losses                                                                                                            |   | 3,522                                               |       | 3,702 |   |
| Provision for credit losses                                                                                                                                       |   | 110                                                 |       | 150 |   |
| Net interest income after provision for credit losses                                                                                                             |   | 3,412                                               |       | 3,552 |   |
| Other operating income:                                                                                                                                           |   |                                                |       |   |   |
| Net gain on sale of securities available-for-sale                                                                                                                 |   | 100                                                 |       | — |   |
| International services                                                                                                                                            |   | 8                                                   |       | 5 |   |
| Investment division                                                                                                                                               |   | 22                                                  |       | 22 |   |
| Deposit-related and other customer services                                                                                                                       |   | 305                                                 |       | 368 |   |
| Total other operating income                                                                                                                                      |   | 435                                                 |       | 395 |   |
| Other operating expenses:                                                                                                                                         |   |                                                |       |   |   |
| Salaries and related benefits                                                                                                                                     |   | 1,827                                               |       | 1,639 |   |
| Net occupancy                                                                                                                                                     |   | 329                                                 |       | 373 |   |
| Furniture and equipment                                                                                                                                           |   | 109                                                 |       | 101 |   |
| Printing and communications                                                                                                                                       |   | 129                                                 |       | 172 |   |
| Insurance and regulatory assessments                                                                                                                              |   | 111                                                 |       | 91 |   |
| Client services                                                                                                                                                   |   | 178                                                 |       | 191 |   |
| Computer data processing                                                                                                                                          |   | 216                                                 |       | 228 |   |
| Legal services                                                                                                                                                    |   | 143                                                 |       | 174 |   |
| Other professional services                                                                                                                                       |   | 225                                                 |       | 74 |   |
| Amortization of core deposit intangible...                                                                                                                     |   | 56                                                  |       | — |   |
| Promotion and other expenses                                                                                                                                      |   | 87                                                  |       | 239 |   |
| Total other operating expenses                                                                                                                                    |   | 3,410                                               |       | 3,282 |   |
| Income before income tax provision and minority interest                                                                                                          |   | 437                                                 |       | 665 |   |
|                                                                                                                                                              |   |                                                |       |   |   |
| Minority interest in the Company’s income of the:                                                                                                            |   |                                                |       |   |   |
| Guaranteed preferred beneficial interests in the Company’s junior  subordinated deferrable interest debentures, net                                          |   | 233                                                 |       | 384 |   |
|                                                                                                                                                              |   |                                                |       |   |   |
| Income before income tax provision                                                                                                                                |   | 204                                                 |       | 281 |   |
|                                                                                                                                                              |   |                                                |       |   |   |
| Income tax provision                                                                                                                                              |   | 107                                                 |       | 106 |   |
| Net income                                                                                                                                                        |   | $                                                   | 97         |   | $ | 175 |   |
| Income available to common shareholders (net income less accretion of  discount of minority interest in subsidiary preferred stock of $79,000 at  March 31, 2002) |   | $                                                   | 97         |   | 96 |   |
| Earnings (loss) per share:                                                                                                                                        |   |                                                |       |   |   |
| Basic                                                                                                                                                             |   | $                                                   | 004        |   | $ | 006 |   |
| Diluted                                                                                                                                                           |   | $                                                   | 002        |   | $ | 004 |   |

 

See accompanying notes to consolidatedfinancial statements

 

3

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**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(Unaudited)

 
|                                                                                        |   | **For the  Three Months Ended March 31,** |    |
|---------------------------------------------------------------------------------------------|--------|-------------------------------------------|---------|
|                                                                                        |   | **2003**                                  |    | **2002** |   |
|                                                                                        |   | **(Dollars  in thousands)**               |    |
| Cash flow from operating activities:                                                        |   |                                      |    |   |   |
| Net income                                                                                  |   | $                                         | 97      |   | $ | 175 |   |
| Adjustments to reconcile net income to net cash used in operating  activities:              |   |                                      |    |   |   |
| Depreciation and amortization                                                               |   | 143                                       |    | 257 |   |
| Provision for credit losses                                                                 |   | 110                                       |    | 150 |   |
| Gain on sale securities available for sale                                                  |   | (100                                      | )  | — |   |
| Net amortization of premium on securities available-for-sale                                |   | 71                                        |    | 53 |   |
| Net amortization of premium (discount) on loans purchased                                   |   | 72                                        |    | (62 | ) |
| Increase (decrease) in accrued interest receivable and other assets                         |   | (2,237                                    | )       | 639 |   |
| Decrease in accrued interest payable and other liabilities                                  |   | (1,213                                    | )       | (1,278 | ) |
| Net cash used in operating activities                                                       |   | (3,057                                    | )       | (66 | ) |
|                                                                                        |   |                                      |    |   |   |
| Cash flows from investing activities:                                                       |   |                                      |    |   |   |
| Purchase of securities available-for-sale                                                   |   | (2,250                                    | )       | — |   |
| Proceeds from sales of securities available-for-sale                                        |   | 2,757                                     |    | — |   |
| Proceeds from repayments and maturities of securities available-for-sale                    |   | 7,512                                     |    | 11,344 |   |
| Proceeds from sales of FRB and other stock                                                  |   | —                                    |    | 504 |   |
| Loan originations and principal collections, net                                            |   | 3,708                                     |    | 5,481 |   |
| Purchases of premises and equipment                                                         |   | (17                                       | )       | (239 | ) |
| Net cash provided by investing activities                                                   |   | 11,710                                    |    | 17,090 |   |
|                                                                                        |   |                                      |    |   |   |
| Cash flows from financing activities:                                                       |   |                                      |    |   |   |
| Net increase in demand deposits, money market and savings accounts                          |   | 11,342                                    |    | 2,635 |   |
| Net decrease in time certificates of deposit                                                |   | (7,481                                    | )       | (8,471 | ) |
| Net decrease in securities sold under agreements to repurchase and  federal funds purchased |   | (684                                      | )       | (79 | ) |
| Net decrease in other borrowings                                                            |   | —                                    |    | (7,000 | ) |
| Net proceeds from exercise of stock options                                                 |   | 33                                        |    | 2 |   |
| Net cash provided by (used in) financing activities                                         |   | 3,210                                     |    | (12,913 | ) |
| Net increase in cash and cash equivalents                                                   |   | 11,863                                    |    | 4,111 |   |
| Cash and cash equivalents, January 1                                                        |   | 37,576                                    |    | 52,093 |   |
| Cash and cash equivalents, March 31                                                         |   | $                                         | 49,439  |   | $ | 56,204 |   |
|                                                                                        |   |                                      |    |   |   |
| Supplemental disclosures of cash flow information:                                          |   |                                      |    |   |   |
| Cash paid for Interest                                                                      |   | 1,400                                     |    | 1,257 |   |
| Transfers to OREO from loans receivable, net                                                |   | 535                                       |    | — |   |

 

See accompanying notes to consolidatedfinancial statements

 

4

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**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**NOTES TO THE UNAUDITED CONSOLIDATED FINANCIALSTATEMENTS**

 

NOTE 1—BASIS OF PRESENTATION AND MANAGEMENT REPRESENTATIONS

 

The unaudited consolidated financialstatements include the accounts of National Mercantile Bancorp (the‘‘Company’’) and its wholly owned subsidiaries, Mercantile National Bank, SouthBay Bank, N.A., and National Mercantile Capital Trust I.  The unaudited consolidated financialstatements reflect all interim adjustments, which are of a normal recurringnature and which, in management’s opinion, are necessary for the fairpresentation of the Company’s consolidated financial position and results ofoperations and cash flows for such interim periods. The results for the quarterended March 31, 2003 are not necessarily indicative of the results expected forany subsequent period or for the full year ending December 31, 2003. Theunaudited consolidated financial statements should be read in conjunction withthe audited consolidated financial statements included in the Company’s AnnualReport on Form 10-KSB for the year ended December 31, 2002.

 

NOTE 2—EARNINGS PER SHARE

 

Basic earnings per share is computed usingthe weighted average number of common shares outstanding during theperiod.  The weighted average number ofcommon shares outstanding used in computing basic earnings per share for thethree months ended March 31, 2003 and 2002 was 2,687,560 and 1,627,166,respectively.  The weighted averagenumber of common shares and common share equivalents outstanding used incomputing diluted earnings per share for the three months ended March 31, 2003and 2002 was 4,350,008 and 4,058,940, respectively. 

 

The following table is a reconciliation ofincome and shares used in the computation of basic and diluted earnings pershare:

 

5

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|                                                                         |   | **Earnings  available to  shareholders** |       | **Weighted  Average  Shares** |       | **Per  Share  Amount** |       |
|------------------------------------------------------------------------------|--------|------------------------------------------|------------|-------------------------------|------------|------------------------|------------|
|                                                                         |   | **(in  thousands)**                      |       |                          |       |                   |       |
|                                                                         |   |                                     | ** ** |                          | ** ** |                   | ** ** |
| *For the three months ended March 31, 2003:*                                 |   |                                     |       |                          |       |                   |       |
| Basic earnings per share                                                     |   | $                                        | 97         |                          | 2,687,560  |                   | $          | 0.04 |   |
|                                                                         |   |                                     |       |                          |       |                   |       |
| Effect of dilutive securities:                                               |   |                                     |       |                          |       |                   |       |
| Options and warrants                                                         |   |                                     |       | 39,219                        |       |                   |       |
| Convertible preferred stock                                                  |   |                                     |       | 1,623,229                     |       |                   |       |
| Diluted earnings per share                                                   |   | $                                        | 97         |                          | 4,350,008  |                   | $          | 0.02 |   |
|                                                                         |   |                                     | ** ** |                          | ** ** |                   | ** ** |
| *For the three months ended March 31, 2002:*                                 |   |                                     |       |                          |       |                   |       |
| Basic earnings per share                                                     |   | $                                        | 96         |                          | 1,627,166  |                   | $          | 0.06 |   |
|                                                                         |   |                                     |       |                          |       |                   |       |
| Accretion of discount of minority interest in preferred stock of  subsidiary |   | 79                                       |       |                          |       |                   |       |
|                                                                         |   |                                     |       |                          |       |                   |       |
| Effect of dilutive securities:                                               |   |                                     |       |                          |       |                   |       |
| Options and warrants                                                         |   |                                     |       | 53,925                        |       |                   |       |
| Convertible preferred stock                                                  |   |                                     |       | 2,377,849                     |       |                   |       |
| Diluted earnings per share                                                   |   | $                                        | 175        |                          | 4,058,940  |                   | $          | 0.04 |   |

 

NOTE 3—CASH AND CASH EQUIVALENTS

 

For purposes of reporting cash flows, cashand cash equivalents include cash and due from banks-demand and federal fundssold.

 

NOTE 4—ALLOWANCE FOR CREDIT LOSSES 

 

Provisions for credit losses charged tooperations reflect management’s judgment of the adequacy of the allowance forcredit losses and are determined through periodic analysis of the loanportfolio.  This analysis includes adetailed review of the classification and categorization of problem loans andloans to be charged off; an assessment of the overall quality andcollectibility of the portfolio; and consideration of the loan loss experience,trends in problem loan concentrations of credit risk, as well as current andexpected future economic conditions (particularly Southern California).Management, in conjunction with an outside firm, performs a periodic risk andcredit analysis, the results of which are reported to the Board of Directors.  Loans charged off during the first quarter2003 were $400,000 compared to $1.4 million during the first quarter of 2002.Recoveries of loans previously charged off were $140,000 during the firstquarter 2003 compared to $160,000 for the same period in 2002.

 

6

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The following table sets forth informationconcerning the Company’s allowance for credit losses for the periods indicated.

 

**Analysis ofChanges in Allowance for Credit Losses**

 
|                                                    |   | **Three  months ended**     |       |
|---------------------------------------------------------|--------|-----------------------------|------------|
|                                                    |   | **March  31,  2003**        |       | **March  31,  2002** |   |
|                                                    |   | **(Dollars  in thousands)** |       |
|                                                    |   |                        | ** ** |   | ** ** |
| Balance, beginning of period                            |   | $                           | 4,846      |   | $ | 6,542 |   |
| Loans charged off:                                      |   |                        |       |   |   |
| Real estate construction and land development           |   | —                      |       | 31 |   |
| Commercial loans:                                       |   | 23                          |       | — |   |
| Secured by commercial real properties                   |   | —                      |       | — |   |
| Other - secured and unsecured                           |   | 379                         |       | 1,342 |   |
| Consumer installment and unsecured loans to individuals |   | —                      |       | 30 |   |
| Total loans charged-off                                 |   | 402                         |       | 1,403 |   |
|                                                    |   |                        |       |   |   |
| Recoveries of loans previously charged off:             |   |                        |       |   |   |
| Real estate construction and land development           |   | —                      |       | 107 |   |
| Commercial loans:                                       |   |                        |       |   |   |
| Secured by commercial real properties                   |   | —                      |       | — |   |
| Other - secured and unsecured                           |   | 87                          |       | 48 |   |
| Consumer installment and unsecured loans to individuals |   | 53                          |       | 5 |   |
| Total recoveries of loans previously charged off        |   | 140                         |       | 160 |   |
| Net (recoveries) charge-offs                            |   | 262                         |       | 1,243 |   |
| Provision for credit losses                             |   | 110                         |       | 150 |   |
| Balance, end of period                                  |   | $                           | 4,694      |   | $ | 5,449 |   |

 

Credit quality is affected by many factorsbeyond the control of the Company, including local and national economies, andfacts may exist which are not known to the Company that adversely affect thelikelihood of repayment of various loans in the loan portfolio and realizationof collateral upon a default. Accordingly, no assurance can be given that theCompany will not sustain loan losses materially in excess of the allowance forcredit losses. In addition, the Office of the Comptroller of the Currency(“OCC”), as an integral part of its examination process, periodically reviewsthe allowance for credit losses and could require additional provisions forcredit losses.

 

NOTE 5—GOODWILL AND OTHER INTANGIBLE ASSETS

 

The Company had goodwill of $2.2 million asof March 31, 2003 and December 31, 2002, and net core deposit intangibles of$2.0 million and $2.1 million, respectively, from the South Bayacquisition.  The gross carrying amountof core

 

7

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deposit intangibles was $2.3million at March 31, 2003 and December 31, 2002, and accumulated amortizationwas $279,000 and $223,000, respectively. The core deposit intangibles are estimated to have a life of 10 yearsand 4 months. Amortization for intangibles for 2003 and each of the next fouryears is estimated to be $223,000 per year. In accordance with SFAS No. 142 goodwill is not amortized.  The Company has no other indefinite-livedintangible assets.

 

NOTE 6—INCOME TAXES

 

Income tax provisions of $107,000 and$106,000 were recorded for the three months ended March 31, 2003 and 2002,respectively.  The difference betweenthe statutory tax rate and the effective tax rate for the three months endedMarch 31, 2003 is due to the amortization of the core deposit intangible notbeing deductible for tax purposes.

 

For tax purposes at March 31, 2003, the Companyhad: (i) federal net operating loss carry forwards (“NOLS”) of approximately$17.9 million, which begin to expire in the year 2009; (ii) California NOLS of$559,000 which will expire in 2005; (iii) a federal alternative minimum tax“AMT” credit of $298,000; and (iv) a California AMT of $16,000.  The AMT credits carry forward indefinitely.

 

NOTE 7—BENEFICIAL CONVERSION RIGHTS OF SUBSIDIARY PREFERRED STOCK

 

The Company recorded $1.8 million additionalpaid in capital, with a corresponding discount to the minority interest inSouth Bay Series A Preferred stock, during the fourth quarter of 2001 relatedto the beneficial conversion rights of the preferred stock of its subsidiary,South Bay Bank, N.A.  The discount wasbeing amortized against retained earnings over the period from the acquisitiondate through the earliest conversion date of the preferred stock, June 30,2005, using the effective yield method. For the three months ended March 31, 2002 the amount of the discountamortized against retained earnings was $79,000. The amortization of the discount is netted against net incometo determine income available to common shareholders for earnings per share inthe 2002 period.  The South Bay Series APreferred stock was fully redeemed in December 2002.

 

8

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NOTE 8—COMPREHENSIVE INCOME

 

Comprehensive income is comprised of netincome and all changes to shareholders’ equity, except those changes resultingfrom investments by shareholders and distributions to shareholders.  Total comprehensive income is as follows:

 
|                                                                          |   | **March  31,** |   |
|-------------------------------------------------------------------------------|--------|----------------|--------|
|                                                                          |   | **2003**       |   | **2002** |   |
| Net income                                                                    |   | $              | 97     |   | $ | 175 |   |
|                                                                          |   |           |   |   |   |
| Other comprehensive income, before tax, and unrealized losses on  securities: |   |           |   |   |   |
| Unrealized loss on securities available for sale                              |   | (188           | )      | (204 | ) |
| Other comprehensive loss, before tax                                          |   | (188           | )      | (204 | ) |
|                                                                          |   |           |   |   |   |
| Income tax expense related to items of other comprehensive income             |   | 78             |   | 85 |   |
| Other comprehensive loss                                                      |   | (110           | )      | (119 | ) |
| Total comprehensive income                                                    |   | $              | (13    | ) | $ | 56 |   |

 

NOTE 9—STOCK-BASED EMPLOYEE COMPENSATIONDISCLOSURE

 

In December 2002 the Financial AccountingStandards Board issued Statement of Financial Accounting Standards No. 148,(“SFAS No. 148”), Accounting for Stock-Based Compensation-Transition andDisclosure.  SFAS No. 148 amendsStatement of Financial Accounting Standards No. 123, (“SFAS No. 123”),Accounting for Stock-Based Compensation, to provide alternative methods oftransition for a voluntary change to the fair value based method of accountingfor stock-based employee compensation. In addition, SFAS No.148 amends the disclosure requirements of SFAS No.123 to require prominent disclosures in both annual  and interim financial statements about the method of accountingfor stock-based employee compensation and the effect of the method used onreported results.  The transitionguidance and annual disclosure provisions are effective for fiscal years endingafter December 15, 2002.  The interimdisclosure provisions are effective for financial reports containing financialstatements for interim periods beginning after December 15, 2002. The Companyadopted the provisions of SFAS No. 148 effective in the first quarter of 2003.

 

The estimated per share weighted average fairvalue of options granted was $4.73 and $3.46 for the three months ended March31, 2003 and 2002, respectively.  TheCompany applies Accounting Principles Board Opinion No. 25 and relatedInterpretations in accounting for the stock incentive plans.  SFAS No. 123, Accounting for Stock-BasedCompensation,

 

9

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encourages, but does notrequire, companies to record compensation cost for stock-based employeecompensation plans at fair value. Accordingly, no compensation cost has been recognized for the plans.  Had compensation cost for the optionsgranted been determined based on the fair value at the grant dates for awardsunder the plans consistent with the method of SFAS No. 123, the Company’s netincome for the three months ended March 31, 2003 and 2002 would have decreasedby $38,000 and $23,000, respectively. Basic and diluted earnings per share would have decreased by $0.01 forthe three months ended March 31, 2003. Basic earnings per share would have decreased by $0.02 for the threemonths ended March 31, 2002 and diluted earnings per share would have remainedunchanged.

 

The fair values of options granted during thethree months ended March 31, 2003 and 2002 were estimated on the date of grantusing the Black-Scholes option-pricing model with the followingweighted-average assumptions used: 2003— no dividend yield, expected volatilityof 60%, risk-free interest rate of 3.82%, and an expected life of 10 years;2002— no dividend yield, expected volatility of 73%, risk-free interest rate of5.24%, and an expected life of 10 years.

 

NOTE 10—DERIVATIVE FINANCIAL INSTRUMENTS

 

In January 2003, the Company entered into ainterest rate swap agreement pursuant to which it exchanged a fixed ratepayment obligation of 10.25% on a notional principal amount of $15.0 millionfor a floating rate interest based on the six-month London InterBank OfferedRate plus 458 basis points for a 29-year period ending July 25, 2031.  The interest rate swap agreement results inthe company paying or receiving the difference between the fixed and floatingrates at specified intervals calculated based on the notional amounts.  The differential paid or received on theinterest rate swap is recognized as an adjustment to interest expense.  At January 25, 2003, the Company was payingan interest rate of 5.93% under the terms of the swap which will reduce itsinterest expense for the year-to-date period ended July 25, 2003, the nextreset date, by $329,000.  The counterparty to the swap has the option to call the swap under a declining premium schedulebeginning July 2006.

 

The interest rate swap reduces the adverseimpact of the Company’s 10.25% fixed rate Trust Preferred Securities in adeclining interest rate environment. The Company does not utilize derivatives for speculative purposes.  Under Statement of Financial AccountingStandards No. 133 this swap transaction is designated as a fair valuehedge.  Accordingly, the ineffectiveportion of the change in the fair value of the swap transaction is recordedeach period in current income.  The termsof the swap are symmetrical with the terms of the Trust Preferred Securities,including the payment deferral terms, and considered highly effective inoffsetting changes in fair value of the Trust Preferred Securities.  Accordingly, an $187,000 increase in thefair value of the swap was recorded in income for the three-month period endedMarch 31, 2003 with an offsetting charge to

 

10

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earnings to reflect a similarincrease in the fair value of the Trust Preferred Securities.   No ineffectiveness was recorded to currentearnings related to the interest rate swap.

 

This swap transaction is designated as a fairvalue hedge.  Accordingly, an $187,000increase in the fair value of the swap was recorded in income for thethree-month period ended March 31, 2003. The terms of the swap are symmetrical with the terms of the TrustPreferred Securities, including the payment deferral terms, and consideredhighly effective in offsetting changes in fair value of the Trust PreferredSecurities.

 

NOTE 11—RECLASSIFICATIONS

 

Certain prior year data have beenreclassified to conform to current year presentation.

 

***Item 2.******                      MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS***

 

National Mercantile Bancorp (“NationalMercantile” on a parent-only basis, and the ‘‘Company’’ on a consolidatedbasis) is the holding company for two subsidiary banks, Mercantile NationalBank (“Mercantile”) and South Bay Bank, N.A. (“South Bay”) (and collectively,“the Banks”).  National Mercantile’sprincipal assets are the capital stock of Mercantile and South Bay.  National Mercantile Capital Trust I is aDelaware statutory business trust formed for the exclusive purpose of issuingand selling trust preferred securities and also is a consolidated subsidiary ofthe Company.

 

**RESULTS OF OPERATIONS**

 

The Company recorded net income of $97,000,or $0.02 diluted earnings per share, for the first quarter of 2003, compared tonet income of $175,000, or $0.04 diluted earnings per share, for the firstquarter of 2002.   Net income per basicshare was $0.04 and $0.06 for the first quarter of 2003 and 2002,respectively.  The decrease in netincome resulted primarily from a $180,000 decrease in net interest income, a$128,000 increase in noninterest expense and a $151,000 decrease interest inthe junior subordinated deferrable interest debentures.

 

11

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Return on average assets during the firstquarter of 2003 was 0.11% compared to 0.19% during the first quarter of 2002.Return on average equity declined to 1.26% during the first quarter of 2003from 2.78% during the first quarter of 2002 as a result of lower earnings and alarger equity base in 2003.

 

NET INTEREST INCOME

 

The decrease in net interest income from thefirst quarter of 2002 to the first quarter of 2003 resulted primarily from: (i)a lower weighted average yield in interest-earning assets and a lower weightedaverage cost of interest-bearing liabilities, which resulted in a reduction inour net yield of interest-earning assets from 4.66% to 4.60%; and (ii) loweraverage amounts of interest-earning assets and interest-bearingliabilities.   The lower yields andcosts were due to the Federal Reserve’s response to the slow economy.  Federal funds sold and securitiesavailable-for-sale averaged $14.5 million and $26.2 million, respectively, forthe three months ended March 31, 2003 compared to $31.4 million and $35.2million, respectively, for the first quarter in 2002.  The decrease in federal funds sold and securitiesavailable-for-sale in the 2003 period compared to 2002 was due to the declinein relatively high-costing time certificates of deposit and other borrowings aswell as the higher average balance of loans receivable.

 

Net interest income was positively affectedby a number of factors including:  (i) ashift in the composition of our interest-earning assets to include a higherpercentage of loans receivable (86.9% in the first quarter of 2003 compared to79.3% in the first quarter of 2002), which have higher yields than otherinterest-earning assets; and (ii) an increase in our net interest-earningassets (interest-earning assets less interest-bearing liabilities) of $13.2million, as we continued to change the composition of our deposits fromhigher-cost time certificates of deposit to noninterest-bearing demanddeposits.

 

Average loans receivable increased $13.9million or 5.4% for the three months ended March 31, 2003 compared to the sameperiod in 2002.  The weighted averageyield on loans receivable declined 77 basis points to 6.19% for the firstquarter 2003.  The lower yields on loansreceivable are due to the sustained decline in interest rates over the past twoyears affecting the yields on adjustable rate loans tied to rate indices aswell as the yields on newly originated fixed rate loans and existing fixed rateloans upon renewal at maturity. Securities available for sale decreased $9.0 million or 25.6% in orderto fund higher yielding loans, reduce higher cost funding sources and to reducethe exposure to a decline in market value in the event that market rates beginto rise.  The weighted average yield onsecurities available for sale was 3.87% and 5.56% for the three months endedMarch 31, 2003 and 2002, respectively, representing a 169 basis point declinefor the 2003 period.  The decline inyield was due to purchases of securities in the declining rate environmentduring 2002 and to a lesser extent, adjustable rate

 

12

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securities in theportfolio.  Federal funds sold averaged$14.5 million and yielded 1.20% during the first quarter of 2003 compared to anaverage of $31.4 million yielding 1.64% for the same period in 2002.

 

Average total deposits decreased $7.7 millionor 2.6% to $292.1 million during the first quarter of 2003 compared to $299.8million during the first quarter of 2002. Federal funds purchased and securities sold under agreements torepurchase averaged $1.1 million and $3.1 million for the three months endedMarch 31, 2003 and 2002, respectively. Average total other borrowings decreased $7.4 million or 49.5% to $7.5million during the quarter ended March 31, 2003 compared to $14.9 millionduring the quarter ended March 31, 2002 reflecting a planned reduction in theserelatively high cost funds provided for by a reduction in securities availablefor sale.

 

The weighted average cost of interest bearingliabilities declined 54 basis points to 1.85% during the first quarter of 2003from 2.39% the during the first quarter of 2002.  This change was a result of a decrease in the weighted averagecost of interest bearing deposits to 1.72% during the first quarter of 2003compared to 2.23% during the first quarter of 2002.  The decline in the weighted average cost of deposits was due to alower volume of higher-costing time certificates of deposit as well as lowerrates on deposits.  The change in thecomposition of deposits reflects management’s emphasis on business banking atSouth Bay, which resulted in lower cost transaction deposit accounts.

 

The weighted average cost of other borrowingswas 4.81 % during the first quarter of 2003 compared to 4.09% during the firstquarter of 2002.  The increase was dueto the maturity of lower costing borrowings

 

Average noninterest-bearing demand depositsincreased $8.2 million or 8.4% during the first quarter 2003 to $105.7 millionfrom $97.5 million due to management’s emphasis on growth in business banking.

 

The following table presents the componentsof net interest income for the quarters ended March 31, 2003 and 2002.

 

13

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**Average Balance Sheet andAnalysis of Net Interest Income**

 
|                                                                                                                      |   | **Three months ended**      |    |
|---------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|---------|
|                                                                                                                      |   | **March 31, 2003**          |    | **March 31, 2002** |   |
|                                                                                                                      |   | **Average  Amount**         |    | **Interest  Income/  Expense** |   | **Weighted  Average  Yield/  Rate** |   | **Average  Amount** |   | **Interest  Income/  Expense** |   | **Weighted  Average  Yield/  Rate** |   |
|                                                                                                                      |   | **(Dollars  in thousands)** |    |
| Assets:                                                                                                                   |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Federal funds sold and  securities purchased under agreements to resell                                                   |   | $                           | 14,511  |   | 43 |   | 1.20 | % | $ | 31,412 |   | $ | 127 |   | 1.64 | % |
| Securities  available-for-sale                                                                                            |   | 26,192                      |    | 250 |   | 3.87 | % | 35,219 |   | 483 |   | 5.56 | % |
| Loans receivable (1) (2)                                                                                                  |   | 269,644                     |    | 4,117 |   | 6.19 | % | 255,711 |   | 4,391 |   | 6.96 | % |
| Total interest earning  assets                                                                                            |   | 310,347                     |    | 4,410 |   | 5.76 | % | 322,342 |   | 5,001 |   | 6.29 | % |
|                                                                                                                      |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Noninterest earning assets:                                                                                               |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks -  demand                                                                                         |   | 20,823                      |    |   |   |   |   | 21,225 |   |   |   |   |   |
| Other assets                                                                                                              |   | 20,157                      |    |   |   |   |   | 24,263 |   |   |   |   |   |
| Allowance for credit losses  and net unrealized gain on sales of securities available-for-sale                            |   | (4,626                      | )       |   |   |   |   | (6,395 | ) |   |   |   |   |
| Total assets                                                                                                              |   | $                           | 346,701 |   |   |   |   |   | $ | 361,435 |   |   |   |   |   |
|                                                                                                                      |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Liabilities and  shareholders’ equity:                                                                               |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing deposits:                                                                                                |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Demand                                                                                                                    |   | $                           | 27,651  |   | 61 |   | 0.89 | % | $ | 27,557 |   | $ | 72 |   | 1.06 | % |
| Money market and savings                                                                                                  |   | 88,976                      |    | 301 |   | 1.37 | % | 78,564 |   | 328 |   | 1.69 | % |
| Time certificates of  deposit:                                                                                            |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| $ 100,000 or more                                                                                                         |   | 28,845                      |    | 147 |   | 2.07 | % | 51,832 |   | 307 |   | 2.40 | % |
| Under $100,000                                                                                                            |   | 40,958                      |    | 282 |   | 2.79 | % | 44,352 |   | 405 |   | 3.70 | % |
| Total time certificates of  deposit                                                                                       |   | 69,803                      |    | 429 |   | 2.49 | % | 96,184 |   | 712 |   | 3.00 | % |
| Total interest-bearing  deposits                                                                                          |   | 186,430                     |    | 791 |   | 1.72 | % | 202,305 |   | 1,112 |   | 2.23 | % |
| Other borrowings                                                                                                          |   | 7,500                       |    | 89 |   | 4.81 | % | 14,856 |   | 150 |   | 4.09 | % |
| Federal funds purchased and  securities sold under agreements to repurchase                                               |   | 1,134                       |    | 8 |   | 2.86 | % | 3,146 |   | 37 |   | 4.77 | % |
| Total interest-bearing  liabilities                                                                                       |   | 195,064                     |    | 888 |   | 1.85 | % | 220,307 |   | 1,299 |   | 2.39 | % |
|                                                                                                                      |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  liabilities:                                                                                         |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Noninterest bearing demand  deposits                                                                                      |   | 105,683                     |    |   |   |   |   | 97,528 |   |   |   |   |   |
| Other liabilities                                                                                                         |   | 225                         |    |   |   |   |   | 3,219 |   |   |   |   |   |
| Guaranteed preferred  beneficial interests in the Company’s junior subordinated deferrable interest  debentures, net |   | 14,532                      |    |   |   |   |   | 14,516 |   |   |   |   |   |
| Minority interest of the  preferred stock of subsidiary                                                                   |   | —                      |    |   |   |   |   | 716 |   |   |   |   |   |
| Shareholders’ equity                                                                                                 |   | 31,197                      |    |   |   |   |   | 25,149 |   |   |   |   |   |
| Total liabilities and  shareholders’ equity                                                                          |   | $                           | 346,701 |   |   |   |   |   | $ | 361,435 |   |   |   |   |   |
|                                                                                                                      |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Net interest income  (spread)                                                                                             |   |                        |    | $ | 3,522 |   | 3.92 | % |   |   | $ | 3,702 |   | 3.90 | % |
|                                                                                                                      |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Net yield on earning assets  (2)                                                                                          |   |                        |    |   |   | 4.60 | % |   |   |   |   | 4.66 | % |
|                                                                                                                           |        |                             |         |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)               The average balance of nonperforming loans hasbeen included in loans receivable.

(2)               Yields and amounts earned on loans receivableinclude loan fees of $190,000 and $141,000 for the three months endedMarch 31, 2003 and 2002, respectively.

 

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The following table sets forth, for the periods indicated, the changesin interest earned and interest paid resulting from changes in volume andchanges in rates.  Average balances inall categories in each reported period were used in the volume computations.  Average yields and rates in each reportedperiod were used in rate computations.

 

**Increase(Decrease) in Interest Income/Expense Due to Change inAverage Volume and Average Rate (1)**

 
|                                                                        |   | **Three months ended March 31,  2003 vs 2002** |   |
|-----------------------------------------------------------------------------|--------|------------------------------------------------|--------|
|                                                                        |   | **Increase (decrease) due to:**                |   | **Net  Increase  (Decrease)** |   |
|                                                                        |   |                                           |   |
|                                                                        |   | **Volume**                                     |   | **Rate** |   |   |
|                                                                        |   |                                           |   |   |   |   |   |
| Interest Income:                                                            |   |                                           |   |   |   |   |   |
| Federal funds sold and  securities purchased under agreement to resell      |   | $                                              | (68    | ) | $ | (16 | ) | $ | (84 | ) |
| Securities  available-for-sale                                              |   | (124                                           | )      | (109 | ) | (233 | ) |
| Loans receivable (2)                                                        |   | 239                                            |   | (513 | ) | (274 | ) |
| Total interest-earning assets                                               |   | 47                                             |   | (638 | ) | (591 | ) |
|                                                                        |   |                                           |   |   |   |   |   |
| Interest Expense:                                                           |   |                                           |   |   |   |   |   |
| Interest-bearing deposits:                                                  |   |                                           |   |   |   |   |   |
| Demand                                                                      |   | $                                              | 0      |   | $ | (11 | ) | $ | (11 | ) |
| Money market and savings                                                    |   | 43                                             |   | (71 | ) | (27 | ) |
| Time certificates of  deposit:                                              |   |                                           |   |   |   |   |   |
| $ 100,000 or more                                                           |   | (136                                           | )      | (24 | ) | (160 | ) |
| Under $100,000                                                              |   | (31                                            | )      | (92 | ) | (123 | ) |
| Total time certificates of  deposit                                         |   | (167                                           | )      | (116 | ) | (283 | ) |
| Total interest-bearing  deposits                                            |   | (124                                           | )      | (198 | ) | (321 | ) |
| Other borrowings                                                            |   | (74                                            | )      | 13 |   | (61 | ) |
| Federal funds purchased and  securities sold under agreements to repurchase |   | (24                                            | )      | (5 | ) | (29 | ) |
| Total interest-bearing  liabilities                                         |   | (221                                           | )      | (190 | ) | (411 | ) |
|                                                                        |   |                                           |   |   |   |   |   |
| Net interest income                                                         |   | $                                              | 269    |   | $ | (449 | ) | $ | (180 | ) |

 

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(1)               The change in interest income or interestexpense that is attributable to both changes in average balance and averagerate has been allocated to the changes due to (i) average balance and (ii)average rate in proportion to the relationship of the absolute amounts ofchanges in each.

(2)               Table does not include interest income thatwould have been earned on nonaccrual loans.

 

15

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PROVISION FOR CREDIT LOSSES

 

Provision for creditlosses for the quarter ended March 31, 2003 was $110,000, compared to $150,000for the quarter ended March 31, 2002. Loan charge-offs during the first quarter of 2003 were $400,000 comparedto $1.4 million during the first quarter of 2002.  Loan charge-offs in the first quarter of 2002 were primarilyrelated to the South Bay loans acquired in December 2001.  Recoveries were $140,000 during the firstquarter of 2003, compared to $160,000 during the first quarter of 2002.

 

OTHER OPERATING INCOME

 

Other operating incomeincreased to $435,000 during the first quarter of 2003 from $395,000 during thefirst quarter of 2002 largely due to net gains on sales of securities of$100,000 for the 2003 period compared to no gains for the 2002 period.  The operating income increase was partiallyoffset by a decline in deposit-related fees earned on the deposit accounts of$63,000 in the first quarter of 2003 compared to the first quarter of 2002.

 

Net gains on sales ofinvestment securities are generated primarily in declining interest rateenvironments.   Accordingly, gains orlosses from sales of investment securities may fluctuate significantly fromperiod to period, and the results in any period are not necessarily indicativeof the results, which may be obtained in future periods.

 

OTHER OPERATING EXPENSES

 

Otheroperating expense increased by $128,000 to $3.4 million during the first quarter of 2003 compared to $3.3million during first quarter of 2002. This increase was reflected as follows; (i) salaries and relatedbenefits increased $188,000, or 11.5%; (ii) net occupancy expense decreased$44,000 or 11.8 %; (iii) printing and communications expense decreased$43,000  or 25.0%; (iv) insurance andregulator assessments expense increased $20,000, or 22.0%; (v) legal expensesdecreased $31,000 , or 17.8% ;  (vi)other professional services increased $151,000, or 204.1%; (vii) other expensesdecreased $152,000 or 63.6% and (viii) amortization of core deposits increased$56,000.

 

Theincrease in salary and related expense in the 2003 period is due to greatertemporary help expense and an increase in incentive bonus accrual.  The temporary help expense is expected todecrease in later quarters, however, it will be largely offset by salaryexpense.  Occupancy expenses decreasedin the three months ended March 31, 2003 due to a rent escallation accrualadjustment decreasing rent expense at Mercantile.  The decline in legal expense for the 2003 period reflects lowerexpenses for credit collection. Other professional expense increased for thethree months ended March 31, 2003 to $225,000

 

16

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from $74,000 during the firstquarter of 2002.  This increase is dueto increased audit expense and a nonrecurring expense related to the sale ofnonperforming assets at South Bay.

 

MINORITY INTEREST IN THE COMPANY’S INCOME

 

The minority interest ofthe guaranteed beneficial interest in the Company’s junior subordinateddeferrable interest debentures (“Trust Preferred Securities”) in the Company’sincome was $233,000 and $384,000 for the three months ended March 31, 2003 and2002, respectively, representing the interest expense of the Trust PreferredSecurities that are classified as mezzanine equity for accounting purposes.

 

The decline in interestexpense of the Trust Preferred Securities is due to an interest rate swapagreement that the Company entered into in January 2003 in which it exchanged afixed rate payment obligation of 10.25% on a notional principal amount of $15.0million for a floating interest rate based on the six-month London InterBankOffered Rate plus 458 basis points for a 29-year period ending July 25, 2031.  The weighted average cost of the TrustPreferred Securities was 6.18% and 10.25% for the three months ended March 31,2003 and 2002, respectively. At January 25, 2003, the Company was paying aninterest rate of 5.93% under the terms of the swap until the next reset date,July 25, 2003.

 

This swap transaction isdesignated as a fair value hedge. Accordingly, an $187,000 increase in the fair value of the swap wasrecorded in income for the three-month period ended March 31, 2003.  The terms of the swap are symmetrical withthe terms of the Trust Preferred Securities, including the payment deferralterms, and considered highly effective in offsetting changes in fair value ofthe Trust Preferred Securities. Accordingly, an offsetting charge to earnings was recorded for the threemonths ended March 31, 2003 to reflect the increase in the fair value of theTrust Preferred Securities.

 

***BALANCESHEET ANALYSIS***

 

INVESTMENT SECURITIES

 

The following comparative period-end table sets forthcertain information concerning the estimated fair values and

unrealized gains and losses ofavailable-for-sale securities:

 

17

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**Estimated Fair Values of and Unrealized**

**Gains and Losses on Investment Securities**

 
|                                                                            |   | **March 31, 2003**         |       |
|---------------------------------------------------------------------------------|--------|----------------------------|------------|
|                                                                            |   | **Total  amortized  cost** |       | **Gross  unrealized  gains** |   | **Gross  unrealized  loss** |   | **Estimated  fair  value** |   |
|                                                                            |   | **(Dollars in thousands)** |       |
|                                                                            |   |                       | ** ** |   | ** ** |   | ** ** |   | ** ** |
| U.S. Treasury securities                                                        |   | $                          | 1,247      |   | $ | — |   | $ | — |   | $ | 1,247 |   |
| GNMA-issued/guaranteed  mortgage pass through certificates                      |   | 770                        |       | 22 |   | — |   | 792 |   |
| FHLMC/FNMA-issued mortgage  pass through certificates                           |   | 9,580                      |       | 360 |   | — |   | 9,940 |   |
| CMO’s and REMIC’s issued by  U.S. government-sponsored  agencies |   | 2,522                      |       | — |   | 13 |   | 2,509 |   |
| Privately issued corporate  bonds, CMO and REMIC securities                     |   | 3,715                      |       | 11 |   | 222 |   | 3,504 |   |
|                                                                            |   | $                          | 17,834     |   | $ | 393 |   | $ | 235 |   | $ | 17,992 |   |
|                                                                            |   |                       |       |   |   |   |   |   |   |
| FRB and other equity stocks                                                     |   | $                          | 2,018      |   | — |   | — |   | $ | 2,018 |   |

 
|                                                                            |   | **December 31, 2002**      |   |
|---------------------------------------------------------------------------------|--------|----------------------------|--------|
|                                                                            |   | **Total  amortized  cost** |   | **Gross  unrealized  gains** |   | **Gross  unrealized  loss** |   | **Estimated  fair  value** |   |
|                                                                            |   | **(Dollars in thousands)** |   |
|                                                                            |   |                       |   |   |   |   |   |   |   |
| U.S. Treasury securities                                                        |   | $                          | 998    |   | $ | — |   | $ | 1 |   | $ | 997 |   |
| GNMA-issued/guaranteed  mortgage pass through certificates                      |   | 2,409                      |   | 73 |   | — |   | 2,482 |   |
| FHLMC/FNMA-issued mortgage  pass through certificates                           |   | 12,370                     |   | 506 |   | — |   | 12,876 |   |
| CMO’s and REMIC’s issued by  U.S. government-sponsored  agencies |   | 4,544                      |   | 44 |   | — |   | 4,588 |   |
| Privately issued corporate  bonds, CMO and REMIC securities                     |   | 5,503                      |   | 12 |   | 288 |   | 5,227 |   |
|                                                                            |   | $                          | 25,824 |   | $ | 635 |   | $ | 289 |   | $ | 26,170 |   |
|                                                                            |   |                       |   |   |   |   |   |   |   |
| FRB and other equity stocks                                                     |   | $                          | 2,018  |   | — |   | — |   | $ | 2,018 |   |

 

The totalamortized cost of investment securities decreased $8.0 million to $17.8 millionat March 31, 2003 from $25.8 million at December 31, 2002 due to maturities,repayments or paydowns on principal amortizing securities during the firstquarter of 2003 and the sale of $2.6 million of securities during this sameperiod.  The Company had a netunrealized gain of $158,000 at March 31, 2003 on its investment securitiesportfolio compared to a net unrealized gain of $346,000 at December 31, 2002.

 

As of March31, 2003 the Company did not hold securities of any issuer, other than U.S.government agencies and corporations, the aggregate book value of whichexceeded 10% of the Company’s shareholders’ equity.

 

18

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Gross realizedgains on sale of securities available-for sale were $100,000 for the threemonths ended March 31, 2003 and $0 for the three months ended March 31, 2002.

 

LOAN PORTFOLIO

 

The followingcomparative period-end table sets forth certain information concerning thecomposition of the loan portfolio. 

 

**LoanPortfolio Composition**

 
|                                                            |   | **March 31,  2003**        |    | **December 31,  2002** |   |
|-----------------------------------------------------------------|--------|----------------------------|---------|------------------------|--------|
|                                                            |   | **Amount**                 |    | **Percent**            |   | **Amount** |   | **Percent** |   |
|                                                            |   | **(Dollars in thousands)** |    |
| Commercial loans:                                               |   |                       |    |                   |   |   |   |   |   |
| Secured by one to four  family residential properties           |   | $                          | 12,067  |                   | 5      | % | $ | 10,797 |   | 4 | % |
| Secured by multifamily  residential properties                  |   | 5,815                      |    | 2                      | %      | 12,596 |   | 5 | % |
| Secured by commercial real  properties                          |   | 129,408                    |    | 48                     | %      | 119,872 |   | 44 | % |
| Other - secured and  unsecured                                  |   | 88,382                     |    | 33                     | %      | 86,015 |   | 32 | % |
| Real estate construction  and land development                  |   | 29,451                     |    | 11                     | %      | 37,934 |   | 14 | % |
| Consumer installment, home  equity                              |   |                       |    |                   |   |   |   |   |   |
| and unsecured loans to  individuals                             |   | 3,171                      |    | 1                      | %      | 5,566 |   | 1 | % |
| Total loans outstanding                                         |   | 268,294                    |    | 100                    | %      | 272,780 |   | 100 | % |
|                                                            |   |                       |    |                   |   |   |   |   |   |
| Deferred net loan  origination fees and purchased loan discount |   | (548                       | )       |                   |   | (457 | ) |   |   |
| Loans receivable, net                                           |   | $                          | 267,746 |                   |   |   | $ | 272,323 |   |   |   |

 

Total loans outstandingdecreased by $4.5 million to $268.3 million at March 31, 2003 compared to$272.8 million at December 31, 2002 as loan payoffs exceeded loanoriginations.  During the quarter, thecompany continued to emphasize origination of commercial loans secured bycommercial real properties and to de-emphasize origination of real estateconstruction and land development loans and commercial loans secured bymulti-family properties. The Company experienced a higher volume of loanoriginations in its commercial real estate loans and other commercial loansduring the first quarter of 2003 from the levels outstanding at December 31,2002.  These increases were more thanoffset by decreases in real estate construction and land development loans andloans secured by multifamily residential properties.  This shift in loans toward

 

19

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commercial real estate andcommercial secured and unsecured was intended to have less concentration in thereal estate construction and multifamily residential properties.

 

NONPERFORMING ASSETS

 

The followingcomparative period-end table sets forth certain information concerningnonperforming assets.

 

**NonperformingAssets**

 
|                                                                                                                        |   | **March 31,  2003**        |   | **December 31  2002** |   |
|-----------------------------------------------------------------------------------------------------------------------------|--------|----------------------------|--------|-----------------------|--------|
|                                                                                                                        |   | **(Dollars in thousands)** |   |
|                                                                                                                        |   |                       |   |                  |   |
| Nonaccrual loans                                                                                                            |   | $                          | 4,308  |                  | $      | 5,787 |   |
| Troubled debt restructurings                                                                                                |   | —                     |   | —                |   |
| Loans contractually past  due ninety or more days with respect to either principal or interest and  still accruing interest |   | —                     |   | 209                   |   |
| Nonperforming loans                                                                                                         |   | 4,308                      |   | 5,996                 |   |
| Other real estate owned                                                                                                     |   | 1,535                      |   | 1,000                 |   |
| Other nonperforming assets                                                                                                  |   | —                     |   | —                |   |
| Total nonperforming assets                                                                                                  |   | $                          | 5,843  |                  | $      | 6,996 |   |
|                                                                                                                        |   |                       |   |                  |   |
| Allowance for credit losses  as a percent of nonaccrual loans                                                               |   | 109.0                      | %      | 83.7                  | %      |
| Allowance for credit losses  as a percent of nonperforming loans                                                            |   | 109.0                      | %      | 80.8                  | %      |
| Total nonperforming assets  as a percent of loans receivable                                                                |   | 2.2                        | %      | 2.6                   | %      |
| Total nonperforming assets  as a percent of total shareholders’ equity                                                 |   | 18.7                       | %      | 22.4                  | %      |

 

Nonaccrual loansdecreased $1.5 million at March 31, 2003 to $4.3 million from $5.8 million atDecember 31, 2002 due primarily to collection of nonaccrual loans and theforeclosure of real estate in satisfaction of a $535,000 nonaccrual loan. Therewere no loans past due 90 days or more and still accruing interest at March 31,2003 compared to $209,000 at December 31, 2002.  As a result, the amount of nonperforming assets at March 31, 2003decreased 16.5% from the level at December 31, 2002.

 

ALLOWANCE FOR CREDITLOSSES

 

Provisions for creditlosses charged to operations reflect management’s judgment of the adequacy ofthe allowance for credit losses and are determined through periodic analysis ofthe loan portfolio.  This analysisincludes a detailed review of the classification and categorization of problemloans and loans to be charged off; an assessment of the overall quality andcollectibility of the portfolio; and consideration of the loan loss experience,trends in problem loan concentrations of credit risk,

 

20

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as well as current and expectedfuture economic conditions (particularly Southern California). Management, inconjunction****with an outside advisory firm,performs a periodic risk and credit analysis, the results of which are reportedto the Board of Directors.

 

Loans charged off duringthe first quarter of 2003 were $400,000 compared to $1.4 million during thefirst quarter of 2002.  Recoveries ofloans previously charged off were $140,000 during the first quarter of 2003compared to $160,000 for the same period in 2002.  The Analysis of Changes in Allowance for Credit Losses isdetailed in Note 4, and the table on page 8.

 

Credit quality isaffected by many factors beyond the control of the Company, including local andnational economies, and facts may exist which are not known to the Company thatadversely affect the likelihood of repayment of various loans in the loanportfolio and realization of collateral upon a default. Accordingly, noassurance can be given that the Company will not sustain loan losses materiallyin excess of the allowance for credit losses. In addition, the Office of theComptroller of the Currency (“OCC”), as an integral part of its examinationprocess, periodically reviews the allowance for credit losses and could requireadditional provisions for credit losses.

 

TOTAL DEPOSITS

 

Total deposits were $302.6million and $298.7 million at March 31, 2003 and December 31, 2002,respectively.  Noninterest-bearingdemand deposits and money market deposits were $114.2 million and $47.1million, respectively, at March 31, 2003 compared to $107.6 million and $43.1million, respectively, at December 31, 2002. The increase in these accounts isattributable to an emphasis on growing business banking, particularly at SouthBay, which generates transaction deposit accounts and an increase in depositsfrom the Company’s escrow customers. Interest-bearing demand deposits, which are largely limited toindividuals, decreased to $27.1 million at March 31, 2003 from $30.5 million atDecember 31, 2002.  Savings depositsincreased to $46.3 million at March 31, 2003 compared to $42.2 million atDecember 31, 2002 reflecting the higher yields being paid on this deposittype.  Time certificates of deposit(“TCDs”) decreased significantly to $67.9 million at March 31, 2003 from $75.4million at December 31, 2002.  Thisdecrease is due to an emphasis on growing lower cost deposit accounts.Additionally, TCDs $100,000 and over decreased due to the termination of a$15.0 million public funds deposit partially offset by $5.0 million of brokeredTCDs in the first quarter of 2003.

 

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FEDERAL FUNDS SOLD AND SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE

 

Federal funds sold andsecurities sold under agreements to repurchase at March 31, 2003 were $792,000compared to $1.5 million at year-end 2002.  The decline is due to the planned runoff of the higher costingliabilities at South Bay.

 

OTHER BORROWINGS

 

Other borrowings were $7.5 million at March31, 2003 and December 31, 2002 representing advances from the Federal Home LoanBank.

 

SHAREHOLDERS’ EQUITY

 

Shareholders’ equity was$31.2 million at March 31, 2003 and December 31, 2002.  The net income for the three months endedMarch 31, 2003 was offset by declines in market value of securitiesavailable-for-sale.

 

***CAPITALADEQUACY REQUIREMENTS***

 

At March 31, 2003 theCompany and the Banks were in compliance with all applicable regulatory capitalrequirements and the Banks were “well capitalized” under the Prompt CorrectiveAction rules of the OCC.  The followingtable sets forth the regulatory capital standards for well capitalizedinstitutions, and the capital ratios for the Company and the Banks as ofMarch 31, 2003 and December 31, 2002.

 

22

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**RegulatoryCapital Informationof the National Mercantile and Banks**

 
|                              |   | **Minimum  For Capital  Adequacy  Purposes** |                | **Well  Capitalized  Standards** |                   |   |   |
|-----------------------------------|--------|----------------------------------------------|---------------------|----------------------------------|------------------------|--------|--------|
|                              |   |                                         |                |
|                              |   |                                         | **March 31,  2003** |                             | **December 31,  2002** |   |
|                              |   |                                         |                |                             |
| **National  Mercantile Bancorp:** |   |                                         |                |                             |                   |   |   |   |   |
| Tier 1 leverage                   |   | 4.00                                         | %                   | N/A                              |                   | 9.07   | %      | 8.60 | % |
| Tier 1 risk-based capital         |   | 4.00                                         | %                   | N/A                              |                   | 10.60  | %      | 10.57 | % |
| Total risk-based capital          |   | 8.00                                         | %                   | N/A                              |                   | 13.30  | %      | 13.31 | % |
|                              |   |                                         |                |                             |                   |   |   |   |   |
| **Mercantile  National Bank:**    |   |                                         |                |                             |                   |   |   |   |   |
| Tier 1 leverage                   |   | 4.00                                         | %                   | 5.00                             | %                      | 8.48   | %      | 7.20 | % |
| Tier 1 risk-based capital         |   | 4.00                                         | %                   | 6.00                             | %                      | 10.91  | %      | 9.89 | % |
| Total risk-based capital          |   | 8.00                                         | %                   | 10.00                            | %                      | 12.17  | %      | 11.15 | % |
|                              |   |                                         |                |                             |                   |   |   |   |   |
| **South Bay  Bank, NA:**          |   |                                         |                |                             |                   |   |   |   |   |
| Tier 1 leverage                   |   | 4.00                                         | %                   | 5.00                             | %                      | 9.07   | %      | 9.38 | % |
| Tier 1 risk-based capital         |   | 4.00                                         | %                   | 6.00                             | %                      | 10.03  | %      | 10.90 | % |
| Total risk-based capital          |   | 8.00                                         | %                   | 10.00                            | %                      | 11.28  | %      | 12.15 | % |

 

***LIQUIDITY***

 

The Company manages itsliquidity through a combination of core deposits, federal funds purchased,repurchase agreements, collateralized borrowing lines, and a portfolio ofsecurities available for sale. Liquidity is also provided by maturing investment securities and loans.

 

National Mercantile is alegal entity separate and distinct from the Banks, and therefore it mustprovide for its own liquidity.  NationalMercantile’s principal sources of funds are proceeds from the sales of securitiesand dividends or capital distributions from the Banks.  In addition to its own operating expenses,National Mercantile is responsible for the payment of the interest on theoutstanding issues of Trust Preferred Securities.  The semi-annual interest payments on the Trust PreferredSecurities, under the terms of the indenture, are deferrable at the Company’soption, for a period up to ten consecutive semi-annual payments, but in anyevent not beyond June 25, 2031.

 

Cash and due from bankswas $18.0 million on March 31, 2003 compared to $18.9 million on December 31,2002.  Federal funds sold were $31.4million and $18.7 million for March 31, 2003 and December 31, 2002,respectively.  Mercantile National Bankhad $5.0 million and South Bay Bank had $12.0 million in Federal funds lineswith correspondent banks as of March 31, 2003.

 

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The payment of dividendsby National Mercantile is limited by the terms of the Trust PreferredSecurities indenture.  NationalMercantile may not declare or pay any dividends or other distributions on itscommon stock or preferred stock if it is in default under the terms of theindenture or if it has elected to defer payments of interest on the TrustPreferred Securities.

 

***ASSET LIABILITY MANAGEMENT***

 

The following tableshows that the Company’s cumulative one-year interest rate sensitivity gapindicated an asset sensitive position of $63.2 million at March 31, 2003, achange from an asset sensitive position of $41.2 million at December 31,2002.  This change resulted primarilyfrom an increase in assets repricing in less than three months, consisting offederal funds sold, securities available for sale and loans receivable and adecrease in time certificates of deposit maturing within one year. This changewas partially offset by an increase in interest-bearing demand, money marketand savings deposit accounts.

 

The Company’s assetsensitive position during a period of slowly declining interest rates is notexpected to have a significant negative impact on net interest income sincerates paid on the Company’s large base of interest bearing demand, savings andmoney market deposit accounts historically have not changed proportionatelywith changes in interest rates. However, since the Company is in an asset sensitive position, in aperiod of rapidly declining rates, such as the environment that was experiencedduring 2001 and 2002, the rapid decline will have a negative effect on theCompany’s net interest income as changes in the rates of interest bearingdeposits historically have not changed in similar magnitude to changes inmarket interest rates.  Additionally, inrelatively low and declining interest rate environments, the interest ratespaid on funding liabilities may begin to reach floors preventing furtherdownward adjustments while rates on earning assets continue to adjust downward.

 

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*** ***

**Table 6**

**Rate-Sensitive Assets and Liabilities**

 
|                                                                     |   | **March 31, 2003**            |   |
|--------------------------------------------------------------------------|--------|-------------------------------|--------|
|                                                                     |   | **Maturing or repricing in**  |   |
|                                                                     |   | **Less  than  three  months** |   | **After three  months  but within  one year** |   | **After one  year  but within  5 years** |   | **After  5 years** |   | **Total** |   |
|                                                                     |   |                          |   |   |   |   |   |   |   |   |   |
|                                                                     |   | **(Dollars in thousands)**    |   |
| Rate-Sensitive Assets:                                                   |   |                          |   |   |   |   |   |   |   |   |   |
| Federal funds sold and  securities purchased under agreements to resell  |   | $                             | 31,400 |   | $ | — |   | $ | — |   | $ | — |   | $ | 31,400 |   |
| Securities  available-for-sale, at amortized cost                        |   | 4,962                         |   | 1,000 |   | 4,078 |   | 7,794 |   | 17,834 |   |
| Due from banks - time                                                    |   | —                        |   | 325 |   | — |   | — |   | 325 |   |
| FRB and other stock, at  cost                                            |   | —                        |   | — |   | — |   | 2,018 |   | 2,018 |   |
| Loans receivable (1)                                                     |   | 198,454                       |   | 10,633 |   | 38,737 |   | 15,614 |   | 263,438 |   |
| Total rate-sensitive assets                                              |   | 234,816                       |   | 11,958 |   | 42,815 |   | 25,426 |   | 315,015 |   |
|                                                                     |   |                          |   |   |   |   |   |   |   |   |   |
| Rate-Sensitive  Liabilities:  (2)                                   |   |                          |   |   |   |   |   |   |   |   |   |
| Interest bearing deposits:                                               |   |                          |   |   |   |   |   |   |   |   |   |
| Demand, money market and  savings                                        |   | 120,532                       |   | — |   | — |   | — |   | 120,532 |   |
| Time certificates of  deposit                                            |   | 25,833                        |   | 36,378 |   | 5,362 |   | 310 |   | 67,883 |   |
| Other borrowings                                                         |   | —                        |   | 792 |   | 7,500 |   | — |   | 8,292 |   |
| Total rate-sensitive  liabilities                                        |   | 146,365                       |   | 37,170 |   | 12,862 |   | 310 |   | 196,707 |   |
| Interest rate-sensitivity  gap                                           |   | 88,451                        |   | (25,212 | ) | 29,953 |   | 25,116 |   | 118,308 |   |
| Cumulative interest  rate-sensitivity gap                                |   | $                             | 88,451 |   | $ | 63,239 |   | $ | 93,192 |   | $ | 118,308 |   |   |   |
| Cumulative ratio of rate  sensitive assets to rate-sensitive liabilities |   | 160                           | %      | 134 | % | 147 | % | 160 | % |   |   |
|                                                                          |        |                               |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)               Loans receivable excludes nonaccrual loans.

(2)               Deposits which are subject to immediatewithdrawal are presented as repricing within three months or less. Thedistribution of other time deposits is based on scheduled maturities.

 

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**Rate-Sensitive Assets and Liabilities**

 
|                                                                     |   | **December  31, 2002**        |   |
|--------------------------------------------------------------------------|--------|-------------------------------|--------|
|                                                                     |   | **Maturing  or repricing in** |   |
|                                                                     |   | **Less  than  three  months** |   | **After  three  months  but within  one year** |   | **After  one  year  but within  5 years** |   | **After  5 years** |   | **Total** |   |
|                                                                     |   |                          |   |   |   |   |   |   |   |   |   |
|                                                                     |   | **(Dollars  in thousands)**   |   |
| Rate-Sensitive Assets:                                                   |   |                          |   |   |   |   |   |   |   |   |   |
| Federal funds sold and securities purchased under agreements to resell   |   | $                             | 18,700 |   | $ | — |   | $ | — |   | $ | — |   | $ | 18,700 |   |
| Securities available-for-sale, at amortized cost                         |   | —                        |   | 998 |   | 1,857 |   | 22,969 |   | 25,824 |   |
| Due from banks - time                                                    |   | —                        |   | 325 |   | — |   | — |   | 325 |   |
| FRB and other stock, at cost                                             |   | —                        |   | — |   | — |   | 2,018 |   | 2,018 |   |
| Loans receivable (1)                                                     |   | 196,286                       |   | 10,907 |   | 40,375 |   | 19,425 |   | 266,993 |   |
| Total rate-sensitive assets                                              |   | 214,986                       |   | 12,230 |   | 42,232 |   | 44,412 |   | 313,860 |   |
|                                                                     |   |                          |   |   |   |   |   |   |   |   |   |
| Rate-Sensitive Liabilities:   (2)                                   |   |                          |   |   |   |   |   |   |   |   |   |
| Interest bearing deposits:                                               |   |                          |   |   |   |   |   |   |   |   |   |
| Demand, money market and savings                                         |   | 115,781                       |   | — |   | — |   | — |   | 115,781 |   |
| Time certificates of deposit                                             |   | 36,882                        |   | 31,865 |   | 6,617 |   | — |   | 75,364 |   |
| Other borrowings                                                         |   | —                        |   | 1,476 |   | 7,500 |   | — |   | 8,976 |   |
| Total rate-sensitive liabilities                                         |   | 152,663                       |   | 33,341 |   | 14,117 |   | — |   | 200,121 |   |
| Interest rate-sensitivity gap                                            |   | 62,323                        |   | (21,111 | ) | 28,115 |   | 44,412 |   | 113,739 |   |
| Cumulative interest rate-sensitivity gap                                 |   | $                             | 62,323 |   | $ | 41,212 |   | $ | 69,327 |   | $ | 113,739 |   |   |   |
| Cumulative ratio of rate sensitive assets to rate-sensitive  liabilities |   | 141                           | %      | 122 | % | 135 | % | 157 | % |   |   |
|                                                                          |        |                               |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)               Loans receivable excludes nonaccrual loans.

(2)               Deposits which are subject to immediatewithdrawal are presented as repricing within three months or less. Thedistribution of other time deposits is based on scheduled maturities.

 

In October 2002,  Mercantile executed an informal non-bindingmemorandum of understanding (“MOU”), with the OCC relating to its interest rate risk management.  The MOU provides for Mercantile to takecertain actions that the OCC believes would strengthen Mercantile’s interestrate risk management process, including the review of its interest rate risklimits and interest rate risk modeling assumptions and the retention of anindependent consultant to conduct a review of Mercantile’s interest rate riskmeasurement processes by February 28, 2003. Mercantile has taken substantive actions provided in the MOU and intendsto continually evaluate and enhance its interest rate risk management processesas appropriate.

 

26

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**FACTORSWHICH MAY AFFECT FUTURE OPERATING RESULTS**

 

Our results ofoperations and financial condition are affected by many factors, including thefollowing.

 

**Weface risk from changes in interest rates.**

 

The success ofour business depends, to a large extent, on our net interest income.  Changes in market interest rates can affectour net interest income by affecting the spread between our interest-earningassets and interest-bearing liabilities. This may be due to the different maturities of our interest-earningassets and interest-bearing liabilities, as well as an increase in the generallevel of interest rates.  Changes inmarket interest rates also affect, among other things:

 

•                  Our ability tooriginate loans;

•                  The ability ofour borrowers to make payments on their loans;

•                  The value of ourinterest-earning assets and our ability to realize gains from the sale of theseassets;

•                  The average lifeof our interest-earning assets;

•                  Our ability togenerate deposits instead of other available funding alternatives; and

•                  Our ability toaccess the wholesale funding market.

 

Interest ratesare highly sensitive to many factors, including governmental monetary policies,domestic and international economic and political conditions and other factorsbeyond our control.

 

**Weface risk from possible declines in the quality of our assets.**

 

Our financialcondition depends significantly on the quality of our assets.  While we have developed and implementedunderwriting policies and procedures to guide us in the making of loans,compliance with these policies and procedures in making loans does notguarantee repayment of the loans.  Ifthe level of our non-performing assets rises, our results of operations andfinancial condition will be affected.  Aborrower’s ability to pay its loan in accordance with its terms can beadversely affected by a number of factors, such as a decrease in the borrower’srevenues and cash flows due to adverse changes in economic conditions or adecline in the demand for the borrower’s products and/or services

.

**Ourallowances for credit losses may be inadequate.**

 

We establishallowances for credit losses against each segment of our loan portfolio.  At March 31, 2003, our allowance for creditlosses equaled 1.8% of loans receivable and 109.0% of nonperforming loans.  Although we believed that we had establishedadequate allowances for credit losses as of March 31, 2003, the credit qualityof our assets is affected by many factors beyond our control, including localand national economic conditions, and the possible existence of facts which arenot

 

27

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known to us which adverselyaffect the likelihood of repayment of various loans in our loan portfolio andrealization of the collateral upon a default. Accordingly, we can give no assurance that we will not sustain loanlosses materially in excess of the allowance for credit losses.  In addition, the Office of the Comptrollerof the Currency, as an integral part of its examination process, periodicallyreviews our allowance for credit losses and could require additional provisionsfor credit losses.  Material futureadditions to the allowance for credit losses may also be necessary due toincreases in the size and changes in the composition of our loan portfolio.  Increases in our provisions for creditlosses would adversely affect our results of operations.

 

**Economicconditions may worsen.**

 

Our businessis strongly influenced by economic conditions in our market area (principally,the Greater Los Angeles metropolitan area) as well as regional and nationaleconomic conditions and in our niche markets, including the entertainmentindustry in Southern California.  Duringthe past several years economic conditions in these areas have been generallyunfavorable.  Should the economiccondition in these areas continue to be unfavorable, the financial condition ofour borrowers could weaken, which could lead to higher levels of loan defaultsor a decline in the value of collateral for our loans.  In addition, an unfavorable economy couldreduce the demand for our loans and other products and services.

 

**Becausea significant amount of the loans we make are to borrowers in California, ouroperations could suffer as a result of local recession or natural disasters inCalifornia.**

 

At March 31,2003, approximately 65% of our loans outstanding were collateralized by realproperties located in California. Because of this concentration in California, our financial position andresults of operations have been and are expected to continue to be influencedby general trends in the California economy and its real estate market.  Real estate market declines may adverselyaffect the values of the properties collateralizing loans.  If the principal balances of our loans,together with any primary financing on the mortgaged properties, equal orexceed the value of the mortgaged properties, we could incur higher losses onsales of properties collateralizing foreclosed loans.  In addition, California historically has been vulnerable tocertain natural disaster risks, such as earthquakes and erosion-caused mudslides,which are not typically covered by the standard hazard insurance policiesmaintained by borrowers.  Uninsureddisasters may adversely impact our ability to recover losses on propertiesaffected by such disasters and adversely impact our results of operations.

 

**Ourbusiness is very competitive.**

 

There isintense competition in Southern California and elsewhere in the United Statesfor banking customers.  We experiencecompetition for deposits from many sources, including credit unions, insurancecompanies and money market and other mutual funds, as well as other commercialbanks and savings institutions.  Wecompete for loans and deposits primarily

 

28

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with other commercial banks,mortgage companies, commercial finance companies and savings institutions.  In recent years out-of-state financialinstitutions have entered the California market, which has also increasedcompetition.  Many of our competitorshave greater financial strength, marketing capability and name recognition thanwe do, and operate on a statewide or nationwide basis.  In addition, recent developments intechnology and mass marketing have permitted larger companies to market loansmore aggressively to our small business customers.  Such advantages may give our competitors opportunities to realizegreater efficiencies and economies of scale than we can.  We can provide no assurance that we will beable to compete effectively against our competition.

 

**Ourbusiness is heavily regulated.**

 

Both NationalMercantile as a bank holding company, and Mercantile and South Bay, as nationalbanks, are subject to significant governmental supervision and regulation,which is intended primarily for the protection of depositors.  Statutes and regulations affecting us may bechanged at any time, and the interpretation of these statutes and regulationsby examining authorities also may change. We cannot assure you that future changes in applicable statutes andregulations or in their interpretation will not adversely affect our business.

 

**Wetest goodwill annually and must record any impairment as a charge to earnings.**

 

Statement ofFinancial Accounting Standards No. 142 “Goodwill and Other Intangible Assets”(“SFAS No. 142”), among other provisions, prescribes that goodwill andintangible assets that have indefinite useful lives will not be amortized butrather tested annually, or more frequently upon the occurrence of certainevents, for impairment.  SFAS No. 142provides specific guidance for the testing of goodwill for impairment, whichmay require re-measurement of the fair value of the reporting unit.  Impairment losses are to be reported as acharge to current period earnings.

 

We recordedgoodwill of $2.2 million in connection with the South Bay acquisition inDecember 2001.  During the fourthquarter of 2002, we completed the required impairment tests of goodwill.  The tests determined that our goodwill wasnot considered impaired.  No assurancecan be given that our goodwill will not become impaired in the future.

 

**We determine annually whether our deferredtax asset will be realized and must establish a valuation allowance ifnecessary to reduce it to its realizable value.**

 

In conjunctionwith the acquisition of South Bay, we reversed our valuation allowance of $6.9million on the deferred tax asset with the related benefit reducinggoodwill.  On a periodic basis, at leastannually, we perform an analysis to determine if

 

29

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it is more likely than not thatsome or all of the gross deferred tax asset will not be realized.  Factors used in the analysis that arereflective of the future realization of a deferred tax asset are:

 

•                  A relativelyconsistent strong earnings history;

•                  Future earningsare assured;

•                  Expectedadequate future taxable income arising from the reversal of temporarydifferences to realize the tax asset;

 

An evaluationallowance may be established to reduce the deferred tax asset to its realizablevalue.  The determination of whether avaluation allowance is necessary involves considering the positive and negativefactors related to whether the deferred tax asset is more likely than not to berealized.  Any adjustment required tothe valuation allowance is coupled with a related entry to income taxexpense.  A charge to earnings will bemade in the event that we determine that a valuation allowance to the deferredtax asset is necessary.

 

***ITEM 3. CONTROLS AND PROCEDURES***

 

The Company’smanagement, including the Chief Executive Officer and Chief Financial Officer,have conducted an evaluation of the effectiveness of the Company’s disclosurecontrols and procedures pursuant to Rule 13a-14 under the Securities ExchangeAct of 1934, as amended, within 90 days of the filing of this quarterly report. Based on that evaluation, the Chief Executive Officer and the Chief FinancialOfficer believe that the Company’s disclosure controls and procedures wereeffective in ensuring that information required to be disclosed by theCompany in this quarterly report has been made known to them in a timelymanner.

 

During thequarter ended March 31, 2003, there were no significant changes in theCompany’s internal controls or in other factors that could significantly affectthose controls.

 

30

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**PART II—OTHERINFORMATION**

 

***Item 1.******          LEGALPROCEEDINGS***

 

None.

 

***Item2.******          CHANGES IN SECURITIES***

 

None.

 

***Item 3.******          DEFAULTSUPON SENIOR SECURITIES***

 

None.

 

***Item 4.******          SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS***

 

None.

 

***Item 5.******          OTHERINFORMATION***

 

None.

 

***Item 6.******          EXHIBITSAND REPORTS ON FORM 8-K***

 

(a)          *Exhibits.*

 

99.1                           Certification of Scott A. Montgomery

99.2                           Certification of David R. Brown

 

(b)      *Reports onForm 8-K.*

 

On January 9, 2003, the Company filed a report on Form 8-K reportingunder Item 5 and Item 7 the Company’s press release regarding an equityplacement and interest rate swap.

 

On March 26, 2003, the Company filed a report on Form 8-K reportingunder Item 5 and Item 7 the Company’s press release regarding fourth quarter2002 operating results.

 

**SIGNATURES**

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|   |         | **NATIONAL MERCANTILE BANCORP**                      |
|--------|--------------|------------------------------------------------------|
|   |         | (Registrant)                                         |
|   |         |                                                 |
| DATE:  | May 15, 2003 |                                                 | /s/ SCOTT A.  MONTGOMERY |
|   |         | **Scott A. Montgomery**                              |
|   |         | Chief Executive Officer                              |
|   |         |                                                 |
| DATE:  | May 15, 2003 |                                                 | /s/ DAVID R.  BROWN |
|   |         | **David R. Brown**                                   |
|   |         | Principal Financial and Principal Accounting Officer |

 

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Certification

 

I, Scott A.Montgomery, certify that:

 

1.               I have reviewedthis quarterly report on Form 10-QSB of National Mercantile Bancorp;

 

2.               Based on myknowledge, this quarterly report does not contain any untrue statement of a materialfact or omit to state a material fact necessary to make the statements made, inlight of the circumstances under which such statements were made, notmisleading with respect to the period covered by this quarterly report;

 

3.               Based on myknowledge, the financial statements, and other financial information includedin this quarterly report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this quarterly report;

 

4.               The registrant’sother certifying officers and I are responsible for establishing andmaintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

 

(a)          designed such disclosurecontrols and procedures to ensure that material information relating to theregistrant, including its consolidated subsidiaries, is made known to us byothers within those entities, particularly during the period in which thisquarterly report is being prepared;

 

(b)         evaluated theeffectiveness of the registrant’s disclosure controls and procedures as of adate within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”); and

 

(c)          presented in thisquarterly report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5.               The registrant’sother certifying officers and I have disclosed, based on our most recentevaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunction):

 

(a)          all significantdeficiencies in the design or operation of internal controls which couldadversely affect the registrant’s ability to record, process, summarize andreport financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

(b)         any fraud, whether or notmaterial, that involves management or other employees who have a significantrole in the registrant’s internal controls; and

 

6.               The registrant’sother certifying officers and I have indicated in this quarterly report whetheror not there were significant changes in internal controls or in other factorsthat could significantly affect internal controls subsequent to the date of ourmost recent evaluation, including any corrective actions with regard tosignificant deficiencies and material weaknesses.

 
| Date:  |  May   15,  2003 |   | /s/ SCOTT A.  MONTGOMERY |   |
|--------|---------------------------------|--------|--------------------------|--------|
|   | Scott A.  Montgomery            |
|   | Chief  Executive Officer        |

 

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Certification

 

I, David R.Brown, certify that:

 

1.               I have reviewedthis quarterly report on Form 10-QSB of National Mercantile Bancorp;

 

2.               Based on myknowledge, this quarterly report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this quarterly report;

 

3.               Based on myknowledge, the financial statements, and other financial information includedin this quarterly report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this quarterly report;

 

4.               The registrant’sother certifying officers and I are responsible for establishing andmaintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

 

(a)          designed such disclosurecontrols and procedures to ensure that material information relating to theregistrant, including its consolidated subsidiaries, is made known to us byothers within those entities, particularly during the period in which thisquarterly report is being prepared;

 

(b)         evaluated theeffectiveness of the registrant’s disclosure controls and procedures as of adate within 90 days prior to the filing date of this quarterly report (the “EvaluationDate”); and

 

(c)          presented in thisquarterly report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5.               The registrant’sother certifying officers and I have disclosed, based on our most recentevaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunction):

 

(a)          all significantdeficiencies in the design or operation of internal controls which couldadversely affect the registrant’s ability to record, process, summarize andreport financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

(b)         any fraud, whether or notmaterial, that involves management or other employees who have a significantrole in the registrant’s internal controls; and

 

6.               The registrant’sother certifying officers and I have indicated in this quarterly report whetheror not there were significant changes in internal controls or in other factorsthat could significantly affect internal controls subsequent to the date of ourmost recent evaluation, including any corrective actions with regard tosignificant deficiencies and material weaknesses.

 
| Date:  |  May   15,  2003 |   | /s/ DAVID R.  BROWN |   |
|--------|---------------------------------|--------|---------------------|--------|
|   | David R.  Brown                 |
|   | Chief  Financial Officer        |

 

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