** **

**UNITED STATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**Form 10-QSB**

 

ý**Quarterlyreport under section 13 or 15(d) of the Securities Exchange Act of 1934**

**for the quarterly period ended  September 30, 2004**

 

o  **Transition report under section 13 or 15(d) of theSecurities Exchange Act of 1934 for the transition period from**              **to**              **.**

 

**CommissionFile Number 0-15982**

 

**NATIONAL MERCANTILE BANCORP**

(Exact name of small business issuer in its charter)

| **California**                                                  |   | **95-3819685**                       |
|-----------------------------------------------------------------|--------|--------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |   | (I.R.S. Employer Identification No.) |
|                                                            |   |                                 |
| **1880  Century Park East**                                     |   | **90067**                            |
| **Los  Angeles, California**                                    |   | (Zip Code)                           |
| (Address to principal executive offices)                        |   |                                 |

 

Issuer’stelephone number, including area code:**  (310)277-2265**

 

                Check whether the issuer:  (1) filed all reports required to be filedby Section 13 or 15(d) of the Exchange Act of 1934 during the past 12 months(or for such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days.    ý Yes    o No

 

**APPLICABLEONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEDING FIVEYEARS:**

Checkwhether the registrant filed all documents and reports required to be filed bySection 12, 13 or 15(d) of the Exchange Act after the distribution of securities under a plan confirmed by acourt.    o Yes       o No

** **

**APPLICABLEONLY TO CORPORATE ISSUERS:**

Statethe number of shares outstanding of each of the issuer’s classes of commonequity, as of the latest practicable dat: The number of shares of Common Stock, no par value, of the issueroutstanding as of  November 10, 2004 was2,950,678.

 

Transitional Small Business Disclosure Format (Checkone):    o Yes       ý No

 

 

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PART I — FINANCIALINFORMATION

 

*Item 1.  FinancialStatements*

 

2

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**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

 
|                                                                                                                                                                                                |   | **September  30,**          |                           | **December  31,**

**2003** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|--------------------------------|-----------------------------|--------|
|                                                                                                                                                                                                |   | **2004**                    |                           |                        |
|                                                                                                                                                                                                |   | **(Unaudited)**             |                           |                        |   |
|                                                                                                                                                                                                |   | **(Dollars  in thousands)** |                           |
| ASSETS                                                                                                                                                                                              |   |                        |                           |
| Cash and due from banks-demand                                                                                                                                                                      |   | $                           | 25,855                         |                        | $      | 24,556 |   |
| Due from banks-interest bearing                                                                                                                                                                     |   | 2,728                       |                           | 4,728                       |   |
| Federal funds sold and securities purchased under agreements to  resell                                                                                                                             |   | 4,000                       |       | 10,000                      |   |
| Cash and cash equivalents                                                                                                                                                                           |   | 32,583                      |                           | 39,284                      |   |
| Securities available-for-sale, at fair value; aggregate amortized  cost of $40,985 and $30,756 at   September 30, 2004 and December 31, 2003, respectively                           |   | 41,021                      |                           | 30,877                      |   |
| Securities held-to-maturity, at amortized cost                                                                                                                                                      |   | 3,776                       |                           | 4,597                       |   |
| FRB and other stock, at cost                                                                                                                                                                        |   | 2,956                       |                           | 1,872                       |   |
| Loans receivable                                                                                                                                                                                    |   | 303,812                     |                           | 260,249                     |   |
| Allowance for credit losses                                                                                                                                                                         |   | (3,850                      | )                              | (3,635                      | )      |
|  Net loans receivable                                                                                                                                                                          |   | 299,962                     |                           | 256,614                     |   |
| Premises and equipment, net                                                                                                                                                                         |   | 5,695                       |                           | 5,444                       |   |
| Other real estate owned                                                                                                                                                                             |   | 1,043                       |                           | 925                         |   |
| Deferred tax asset                                                                                                                                                                                  |   | 5,544                       |                           | 6,950                       |   |
| Goodwill                                                                                                                                                                                            |   | 3,225                       |                           | 3,225                       |   |
| Intangible assets, net                                                                                                                                                                              |   | 1,686                       |                           | 1,854                       |   |
| Accrued interest receivable and other assets                                                                                                                                                        |   | 7,967                       |                           | 3,564                       |   |
| Total assets                                                                                                                                                                                        |   | $                           | 405,458                        |                        | $      | 355,206 |   |
|                                                                                                                                                                                                |   |                        |                           |                        |   |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                                                                                           |   |                        |                           |                        |   |
| Deposits:                                                                                                                                                                                           |   |                        |                           |                        |   |
| Noninterest-bearing demand                                                                                                                                                                          |   | $                           | 121,503                        |                        | $      | 119,998 |   |
| Interest-bearing demand                                                                                                                                                                             |   | 30,832                      |                           | 29,349                      |   |
| Money market                                                                                                                                                                                        |   | 72,702                      |                           | 55,422                      |   |
| Savings                                                                                                                                                                                             |   | 34,744                      |                           | 38,925                      |   |
| Time certificates of deposit:                                                                                                                                                                       |   |                        |                           |                        |   |
| $100,000 or more                                                                                                                                                                                    |   | 40,833                      |                           | 27,308                      |   |
| Under $100,000                                                                                                                                                                                      |   | 21,935                      |                           | 27,715                      |   |
| Total deposits                                                                                                                                                                                      |   | 322,549                     |                           | 298,717                     |   |
|                                                                                                                                                                                                |   |                        |                           |                        |   |
| Federal funds purchased and securities sold under agreements to  repurchase                                                                                                                         |   | —                      |                           | 399                         |   |
| Other borrowings                                                                                                                                                                                    |   | 31,900                      |                           | 7,500                       |   |
| Junior subordinated deferrable interest debentures                                                                                                                                                  |   | 15,464                      |                           | 15,464                      |   |
| Accrued interest payable and other liabilities                                                                                                                                                      |   | 1,607                       |                           | 1,405                       |   |
| Total liabilities                                                                                                                                                                                   |   | 371,520                     |                           | 323,485                     |   |
|                                                                                                                                                                                                |   |                        |                           |                        |   |
| 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 666,273 shares and 729,585 shares at  September 30, 2004 and December 31, 2003, respectively |   | 5,442                       |                           | 5,959                       |   |
| Series B non-cumulative convertible perpetual preferred stock;  authorized 1,000 shares; outstanding 1,000 shares at September 30, 2004 and  December 31, 2003                                      |   | 1,000                       |                           | 1,000                       |   |
| Common stock, no par value; authorized 10,000,000 shares; outstanding  2,924,078 shares and 2,772,279 shares at September 30, 2004 and December 31,  2003, respectively                             |   | 39,284                      |                           | 38,602                      |   |
| Accumulated deficit                                                                                                                                                                                 |   | (12,404                     | )                              | (13,911                     | )      |
| Accumulated other comprehensive income                                                                                                                                                              |   | 616                         |                           | 71                          |   |
| Total shareholders’ equity                                                                                                                                                                     |   | 33,938                      |                           | 31,721                      |   |
| Total liabilities and shareholders’ equity                                                                                                                                                     |   | $                           | 405,458                        |                        | $      | 355,206 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

3

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**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

(Unaudited)

 
|                                                                                                                     |   | **For the  Three Months Ended September 30,**  |       | **For the  Nine Months Ended September 30,**   |       |
|--------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------|------------|-----------------------------------------------------|------------|
|                                                                                                                     |   |                                                |       |
|                                                                                                                     |   | **2004**                                            |       | **2003**                                            |       | **2004** |   | **2003** |   |
|                                                                                                                     |   | **(Dollars  in thousands,  except per share data)** |       | **(Dollars  in thousands,  except per share data)** |       |
|                                                                                                                     |   |                                                |       |
| Interest income:                                                                                                         |   |                                                | ** ** |                                                | ** ** |   | ** ** |   | ** ** |
| Loans, including fees                                                                                                    |   | $                                                   | 5,067      |                                                | $          | 3,914 |   | $ | 12,772 |   | $ | 12,121 |   |
| Securities                                                                                                               |   | 403                                                 |       | 251                                                 |       | 1,073 |   | 660 |   |
| Due from banks - interest bearing                                                                                        |   | 12                                                  |       | 5                                                   |       | 40 |   | 5 |   |
| Federal funds sold and securities purchased under agreements to  resell                                                  |   | 5                                                   |       | 92                                                  |       | 59 |   | 268 |   |
| Total interest income                                                                                                    |   | 5,487                                               |       | 4,262                                               |       | 13,944 |   | 13,054 |   |
| Interest expense:                                                                                                        |   |                                                |       |                                                |       |   |   |   |   |
| Interest-bearing demand                                                                                                  |   | 19                                                  |       | 21                                                  |       | 55 |   | 110 |   |
| Money market and savings                                                                                                 |   | 195                                                 |       | 181                                                 |       | 541 |   | 736 |   |
| Time certificates of deposit:                                                                                            |   |                                                |       |                                                |       |   |   |   |   |
| $100,000 or more                                                                                                         |   | 93                                                  |       | 163                                                 |       | 250 |   | 429 |   |
| Under $100,000                                                                                                           |   | 121                                                 |       | 138                                                 |       | 339 |   | 657 |   |
| Total interest expense on deposits                                                                                       |   | 428                                                 |       | 503                                                 |       | 1,185 |   | 1,932 |   |
| Federal funds purchased and securities sold under agreements to  repurchase                                              |   | —                                              |       | 3                                                   |       | 1 |   | 14 |   |
| Junior subordinated deferrable interest debentures                                                                       |   | 259                                                 |       | 228                                                 |       | 713 |   | 228 |   |
| Other borrowings                                                                                                         |   | 105                                                 |       | 89                                                  |       | 277 |   | 267 |   |
| Total interest expense                                                                                                   |   | 792                                                 |       | 823                                                 |       | 2,176 |   | 2,441 |   |
| Net interest income before provision for credit losses                                                                   |   | 4,695                                               |       | 3,439                                               |       | 11,768 |   | 10,613 |   |
| Provision for credit losses                                                                                              |   | 120                                                 |       | 10                                                  |       | 120 |   | 1,265 |   |
| Net interest income after provision for credit losses                                                                    |   | 4,575                                               |       | 3,429                                               |       | 11,648 |   | 9,348 |   |
| Other operating income:                                                                                                  |   |                                                |       |                                                |       |   |   |   |   |
| Net gain (loss) on sale of securities available-for-sale                                                                 |   | (95                                                 | )          | —                                              |       | (76 | ) | 100 |   |
| International services                                                                                                   |   | 25                                                  |       | 19                                                  |       | 46 |   | 34 |   |
| Investment division                                                                                                      |   | 13                                                  |       | 22                                                  |       | 38 |   | 66 |   |
| Deposit-related and other customer services                                                                              |   | 374                                                 |       | 356                                                 |       | 1,176 |   | 977 |   |
| Loss on sale of other real estate owned                                                                                  |   | —                                              |       | —                                              |       | — |   | (61 | ) |
| Total other operating income                                                                                             |   | 317                                                 |       | 397                                                 |       | 1,184 |   | 1,116 |   |
|                                                                                                                     |   |                                                |       |                                                |       |   |   |   |   |
| Other operating expenses:                                                                                                |   |                                                |       |                                                |       |   |   |   |   |
| Salaries and related benefits                                                                                            |   | 1,884                                               |       | 1,792                                               |       | 5,639 |   | 5,462 |   |
| Net occupancy                                                                                                            |   | 270                                                 |       | 333                                                 |       | 885 |   | 1,006 |   |
| Premises and equipment                                                                                                   |   | 91                                                  |       | 112                                                 |       | 389 |   | 346 |   |
| Printing and communications                                                                                              |   | 144                                                 |       | 143                                                 |       | 425 |   | 405 |   |
| Insurance and regulatory assessments                                                                                     |   | 107                                                 |       | 97                                                  |       | 327 |   | 292 |   |
| Client services                                                                                                          |   | 156                                                 |       | 129                                                 |       | 436 |   | 449 |   |
| Computer data processing                                                                                                 |   | 236                                                 |       | 261                                                 |       | 721 |   | 726 |   |
| Legal services                                                                                                           |   | 53                                                  |       | 122                                                 |       | 234 |   | 382 |   |
| Other professional services                                                                                              |   | 226                                                 |       | 206                                                 |       | 599 |   | 613 |   |
| Amortization of core deposit intangible                                                                                  |   | 55                                                  |       | 56                                                  |       | 167 |   | 168 |   |
| Retirement of premises and equipment                                                                                     |   | —                                              |       | —                                              |       | 43 |   | — |   |
| Promotion and other expenses                                                                                             |   | 156                                                 |       | 41                                                  |       | 375 |   | 263 |   |
| Total other operating expenses                                                                                           |   | 3,378                                               |       | 3,292                                               |       | 10,240 |   | 10,112 |   |
| Income before income tax provision and minority interest                                                                 |   | 1,514                                               |       | 534                                                 |       | 2,592 |   | 352 |   |
|                                                                                                                     |   |                                                |       |                                                |       |   |   |   |   |
| Minority interest in the Company’s income of the:                                                                   |   |                                                |       |                                                |       |   |   |   |   |
| Guaranteed preferred beneficial interests in the Company’s junior  subordinated deferrable interest debentures, net |   | —                                              |       | —                                              |       | — |   | 456 |   |
|                                                                                                                     |   |                                                |       |                                                |       |   |   |   |   |
| Income (loss) before income tax provision                                                                                |   | 1,514                                               |       | 534                                                 |       | 2,592 |   | (104 | ) |
|                                                                                                                     |   |                                                |       |                                                |       |   |   |   |   |
| Income tax provision                                                                                                     |   | 642                                                 |       | 242                                                 |       | 1,084 |   | 26 |   |
| Net income (loss)                                                                                                        |   | $                                                   | 872        |                                                | $          | 292 |   | $ | 1,508 |   | $ | (130 | ) |
| Earnings (loss) per share:                                                                                               |   |                                                |       |                                                |       |   |   |   |   |
| Basic                                                                                                                    |   | $                                                   | 0.30       |                                                | $          | 0.11 |   | $ | 0.52 |   | $ | (0.05 | ) |
| Diluted                                                                                                                  |   | $                                                   | 0.19       |                                                | $          | 0.07 |   | $ | 0.33 |   | $ | (0.05 | ) |
|                                                                                                                     |   |                                                |       |                                                |       |   |   |   |   |
| Weighted average shares outstanding, basic                                                                               |   | 2,918,583                                           |       | 2,700,935                                           |       | 2,878,595 |   | 2,694,670 |   |
| Weighted average shares outstanding, diluted                                                                             |   | 4,565,380                                           |       | 4,402,571                                           |       | 4,593,927 |   | 2,694,670 |   |
|                                                                                                                          |        |                                                     |            |                                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

See accompanying notes to consolidated financial statements.

 

4

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** **

**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(Unaudited)

** **
|                                                                                         |   | **For the  Nine Months Ended September 30,** |   |
|----------------------------------------------------------------------------------------------|--------|----------------------------------------------|--------|
|                                                                                         |   | **2004**                                     |   | **2003** |   |
|                                                                                         |   | **(Dollars  in thousands)**                  |   |
| Cash flows from operating activities:                                                        |   |                                         |   |   |   |
| Net income (loss)                                                                            |   | $                                            | 1,508  |   | $ | (130 | ) |
| Adjustments to reconcile net income to net cash provided by (used in)  operating activities: |   |                                         |   |   |   |
| Depreciation and amortization                                                                |   | 338                                          |   | 362 |   |
| Provision for credit losses                                                                  |   | 120                                          |   | 1,265 |   |
| Gain on sale of securities available for sale                                                |   | 76                                           |   | (100 | ) |
| Loss on sales of OREO                                                                        |   | —                                       |   | 61 |   |
| Net amortization of premium on securities available-for-sale                                 |   | 171                                          |   | 161 |   |
| Net amortization of premium on securities held-to-maturity                                   |   | 37                                           |   | — |   |
| Net amortization of core deposit intangible                                                  |   | 167                                          |   | 168 |   |
| Net amortization of premium on loans purchased                                               |   | 145                                          |   | 204 |   |
| Decrease (increase) in accrued interest receivable and other assets                          |   | (3,429                                       | )      | 632 |   |
| Increase (decrease) in accrued interest payable and other liabilities                        |   | 202                                          |   | (1,212 | ) |
| Net cash (used in) provided by operating activities                                          |   | (665                                         | )      | 1,411 |   |
| Cash flows from investing activities:                                                        |   |                                         |   |   |   |
| Purchase of securities available-for-sale                                                    |   | (22,532                                      | )      | (36,334 | ) |
| Proceeds from sales of securities available-for-sale                                         |   | 6,397                                        |   | 2,757 |   |
| Proceeds from repayments and maturities of securities  available-for-sale                    |   | 5,586                                        |   | 21,321 |   |
| Proceeds from sales of OREO                                                                  |   | —                                       |   | 474 |   |
| Proceeds from repayments and maturities of securities  held-to-maturity                      |   | 784                                          |   |   |   |
| Loan originations and principal collections, net                                             |   | (42,596                                      | )      | 21,597 |   |
| Redemption (purchase) of Federal Reserve stock and other stocks                              |   | (1,084                                       | )      | 149 |   |
| Purchases of premises and equipment                                                          |   | (589                                         | )      | (78 | ) |
| Net cash (used in) provided by investing activities                                          |   | (54,034                                      | )      | 9,886 |   |
| Cash flows from financing activities:                                                        |   |                                         |   |   |   |
| Net increase in demand deposits, money market and savings accounts                           |   | 16,087                                       |   | 35,377 |   |
| Net increase (decrease) in time certificates of deposit                                      |   | 7,745                                        |   | (18,677 | ) |
| Net decrease in securities sold under agreements to repurchase and  federal funds purchased  |   | (399                                         | )      | (1,079 | ) |
| Net increase in other borrowings                                                             |   | 24,400                                       |   | — |   |
| Net proceeds from exercise of stock options                                                  |   | 165                                          |   | 96 |   |
| Net cash provided by financing activities                                                    |   | 47,998                                       |   | 15,717 |   |
| Net (decrease) increase in cash and cash equivalents                                         |   | (6,701                                       | )      | 27,014 |   |
| Cash and cash equivalents, January 1                                                         |   | 39,284                                       |   | 37,576 |   |
| Cash and cash equivalents, September 30                                                      |   | $                                            | 32,583 |   | $ | 64,590 |   |
|                                                                                         |   |                                         |   |   |   |
| Supplemental disclosures of cash flow information:                                           |   |                                         |   |   |   |
| Cash paid for interest                                                                       |   | $                                            | 2,358  |   | $ | 2,825 |   |
| Transfers to OREO from loans receivable, net                                                 |   | —                                       |   | 535 |   |
| Cash paid for income taxes                                                                   |   | $                                            | 51     |   | $ | — |   |

 

See accompanying notes to consolidatedfinancial statements.

 

5

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** **

**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIESNOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

 

NOTE1—BASIS OF PRESENTATION AND MANAGEMENT REPRESENTATIONS

 

The unaudited consolidated financialstatements include the accounts of National Mercantile Bancorp (“NationalMercantile” on a parent-only basis, and the ‘‘Company’’ on a consolidatedbasis) and its wholly owned subsidiaries, Mercantile National Bank and SouthBay Bank, N.A., (collectively, the “Banks”). The Company adopted FASBInterpretation No. 46 Consolidation of Variable Interest Entities effectiveJuly 1, 2003 and accordingly the accounts of National Mercantile Capital TrustI are not included in the consolidated balance sheets at September 30, 2004 andDecember 31, 2003 or the consolidated statement of operations for the three andnine months ended September 30, 2004. The unaudited consolidated financial statements reflect all interimadjustments, which are of a normal recurring nature and which, in management’sopinion, are necessary for the fair presentation of the Company’s consolidatedfinancial position and results of operations and cash flows for such interimperiods. The results for the three and nine months ended September 30, 2004 arenot necessarily indicative of the results expected for any subsequent period orfor the full year ending December 31, 2004. The unaudited consolidatedfinancial statements should be read in conjunction with the auditedconsolidated financial statements included in the Company’s Annual Report onForm 10-KSB for the year ended December 31, 2003.

 

 

NOTE2—EARNINGS PER SHARE

 

         Basic earnings per share are computedusing the weighted average number of common shares outstanding during theperiod.  The weighted average number ofcommon shares outstanding used in computing basic earnings per share anddiluted earnings per share was 2,918,583 and 4,565,380, respectively, for thethree months ended September 30, 2004 and 2,878,595 and 4,593,927,respectively, for the nine months ended September 30, 2004.   The weighted average number of commonshares outstanding used in computing basic earnings per share and dilutedearnings per share was 2,700,935 and 4,402,571, respectively, for the threemonths ended September 30, 2003.  Theweighted average number of common shares outstanding used in computing basicand diluted loss per share was 2,694,670 for the nine months ended September30, 2003.

 

         The following table is a reconciliationof income and shares used in the computation of basic and diluted earnings andloss per share: 

 

 

6

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| ** **                                        |   | **Net Income  (Loss)** | ** ** | **Weighted  Average  Shares** | ** ** | **Per share  amount** | ** ** |
|---------------------------------------------------|--------|------------------------|------------|-------------------------------|------------|-----------------------|------------|
|                                              |   | **(in thousands)**     | ** ** |                          | ** ** |                  | ** ** |
|                                              |   |                   |       |                          |       |                  |       |
| *For the  three months ended September 30, 2004:* |   |                   |       |                          |       |                  |       |
| Basic EPS                                         |   | $                      | 872        |                          | 2,918,583  |                  | $          | 0.30 |   |
|                                              |   |                   |       |                          |       |                  |       |
| Effect of dilutive securities:                    |   |                   |       |                          |       |                  |       |
| Options                                           |   |                   |       | 138,431                       |       |                  |       |
| Convertible preferred stock                       |   |                   |       | 1,508,365                     |       |                  |       |
| Diluted earnings per share                        |   | $                      | 872        |                          | 4,565,380  |                  | $          | 0.19 |   |
|                                              |   |                   |       |                          |       |                  |       |
| *For the  three months ended September 30, 2003:* |   |                   |       |                          |       |                  |       |
| Basic and diluted loss per share                  |   | $                      | 292        |                          | 2,700,935  |                  | $          | 0.11 |   |
|                                              |   |                   |       |                          |       |                  |       |
| Effect of diultive securities:                    |   |                   |       |                          |       |                  |       |
| Options                                           |   |                   |       | 72,354                        |       |                  |       |
| Convertible preferred stock                       |   |                   |       | 1,629,282                     |       |                  |       |
| Diluted earnings per share                        |   | 292                    |       | 4,402,571                     |       | $                     | 0.07       |   |
|                                              |   |                   |       |                          |       |                  |       |
| *For the  nine months ended September 30, 2004:*  |   |                   |       |                          |       |                  |       |
| Basic EPS                                         |   | $                      | 1,508      |                          | 2,878,595  |                  | $          | 0.52 |   |
|                                              |   |                   |       |                          |       |                  |       |
| Effect of dilutive securities:                    |   |                   |       |                          |       |                  |       |
| Options                                           |   |                   |       | 209,998                       |       |                  |       |
| Convertible preferred stock                       |   |                   |       | 1,505,333                     |       |                  |       |
| Diluted earnings per share                        |   | $                      | 1,508      |                          | 4,593,927  |                  | $          | 0.33 |   |
|                                              |   |                   |       |                          |       |                  |       |
| *For the  nine months ended September 30, 2003:*  |   |                   |       |                          |       |                  |       |
| Basic and diluted loss per share                  |   | $                      | (130       | )                             | 2,694,670  |                  | $          | (0.05 | ) |
|                                                   |        |                        |            |                               |            |                       |            |  |  |  |

 

 

NOTE3—CASH AND CASH EQUIVALENTS

 

For purposes of reporting cash flows,cash and cash equivalents include cash, due from banks-demand, due frombanks-interest-bearing and federal funds sold.

 

 

NOTE4—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 

 

7

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classificationand categorization of problem loans and loans to be charged off; an assessmentof the overall quality and collectibility of the portfolio; and considerationof the loan loss experience, trends in problem loans, concentrations of creditrisk, as well as current and expected future economic conditions (particularlySouthern California). Management performs a periodic risk and credit analysis,the results of which are reported to the Board of Directors.

 

The following table sets forthinformation concerning the Company’s allowance for credit losses for theperiods indicated.

 

**Analysis of Changes in Allowance for Credit Losses**

 
|                                                                                  |   | **Three months ended**     |       | **Nine months ended**      |       |
|---------------------------------------------------------------------------------------|--------|----------------------------|------------|----------------------------|------------|
|                                                                                  |   | **September 30,**          |       | **September 30,**          |       | **September 30,** |   | **September 30,** |   |
|                                                                                  |   | **2004**                   |       | **2003**                   |       | **2004** |   | **2003** | ** ** |
|                                                                                  |   | **(Dollars in thousands)** |       | **(Dollars in thousands)** | ** ** |
|                                                                                  |   |                       | ** ** |                       | ** ** |   | ** ** |   | ** ** |
| Balance,  beginning of period                                                         |   | $                          | 3,691      |                       | $          | 3,452 |   | $ | 3,635 |   | $ | 4,846 |   |
| Loans charged  off:                                                                   |   |                       |       |                       |       |   |   |   |   |
| Real estate  loans:                                                                   |   |                       |       |                       |       |   |   |   |   |
| Secured by one  to four family residential properties                                 |   | —                     |       | (7                         | )          | — |   | 31 |   |
| Secured by multifamily  residential properties                                        |   | —                     |       | —                     |       | — |   | 75 |   |
| Secured by  commercial real properties                                                |   | —                     |       | —                     |       | — |   | — |   |
| Real estate  construction and land development                                        |   | —                     |       | —                     |       | — |   | — |   |
| Commercial -  secured and unsecured                                                   |   | —                     |       | 1                          |       | 31 |   | 2,698 |   |
| Consumer  installment, home equity lines of credit and unsecured loans to individuals |   | —                     |       | 13                         |       | 4 |   | 46 |   |
|                                                                                  |   |                       |       |                       |       |   |   |   |   |
| Total loans  charged-off                                                              |   | —                     |       | 7                          |       | 35 |   | 2,850 |   |
|                                                                                  |   |                       |       |                       |       |   |   |   |   |
| Recoveries of  loans previously charged off:                                          |   |                       |       |                       |       |   |   |   |   |
| Real estate  loans:                                                                   |   |                       |       |                       |       |   |   |   |   |
| Secured by one  to four family residential properties                                 |   | —                     |       | —                     |       | — |   | — |   |
| Secured by  multifamily residential properties                                        |   | —                     |       | —                     |       | — |   | — |   |
| Secured by  commercial real properties                                                |   | —                     |       | 13                         |       | — |   | 13 |   |
| Real estate  construction and land development                                        |   | —                     |       | —                     |       | 6 |   | — |   |
| Commercial -  secured and unsecured                                                   |   | 26                         |       | 114                        |       | 94 |   | 247 |   |
| Consumer  installment, home equity lines of credit and unsecured loans to individuals |   | 13                         |       | 6                          |       | 30 |   | 67 |   |
| Total recoveries  of loans previously charged off                                     |   | 39                         |       | 133                        |       | 130 |   | 327 |   |
| Net charge-offs  (recoveries)                                                         |   | (39                        | )          | (126                       | )          | (95 | ) | 2,523 |   |
| Provision for  credit losses                                                          |   | 120                        |       | 10                         |       | 120 |   | 1,265 |   |
| Balance, end of  period                                                               |   | $                          | 3,850      |                       | $          | 3,588 |   | $ | 3,850 |   | $ | 3,588 |   |
|                                                                                       |        |                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

         Credit quality is affected by manyfactors beyond the control of the Company, including local and nationaleconomies, and facts may exist which are not known to the Company thatadversely affect the likelihood of repayment of various loans in 

 

8

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theloan portfolio 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, as an integral part of its examination process,periodically reviews the allowance for credit losses and could requireadditional provisions for credit losses.

 

NOTE5—GOODWILL AND OTHER INTANGIBLE ASSETS

 

         As of September 30, 2004 and December31, 2003, the Company had goodwill of $3.2 million, and net core depositintangibles of $1.7 million and $1.9 million, respectively, from itsacquisition of South Bay Bank in December 2001.  The gross carrying amount of core deposit intangibles was $2.3million at September 30, 2004 and December 31, 2003, and accumulatedamortization was $614,000 and $447,000, respectively, at such dates.  The core deposit intangibles are estimatedto have a life of 10 years and 4 months. Amortization for intangibles for 2004and each of the next four years is estimated to be $223,000 per year.  In accordance with SFAS No. 142 goodwill isnot amortized.  The Company has no otherrecorded indefinite-lived intangible assets. Goodwill and other intangible assets are reviewed and assessed annuallyfor impairment.

 

NOTE6—INCOME TAXES

 

An income tax provision of $642,000 and$242,000 were recorded for the three months ended September 30, 2004 and 2003,respectively.  Income tax provision of$1,084,000 and $26,000 were recorded for the nine months ended September 30,2004 and 2003, respectively.

 

At September 30, 2004, the Company had:(i) federal net operating loss carry forwards (“NOLS”) of approximately $16.2million, which begin to expire in the year 2009; (ii) California NOLS of$273,000 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 California NOLS were scheduled to expirein 2002; the state legislature suspended NOLS utilization and extended therelated carry forwards expiration.  TheAMT credits carry forward indefinitely.

 

Management believes that it is morelikely than not that the deferred tax asset will be realized.  Accordingly, no valuation allowance has beenestablished against the deferred tax asset.

 

 

9

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NOTE7—BENEFIT PLANS

 

         There were no stock options granted inthe three months ended September 30, 2004. The estimated per share weighted average fair value of options grantedin the three months ended September 30, 2003 was $4.92.  The estimated per share weighted averagefair value of options granted for the nine months ended September 30, 2004 and2003 was $6.95 and $4.78, respectively. The Company applies AccountingPrinciples Board Opinion No. 25 and related Interpretations in accounting forits stock incentive plans.  SFASNo. 123, Accounting for Stock-Based Compensation, 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 theoptions.  Had compensation cost for theoptions granted been determined based on the fair value at the grant dates forawards consistent with the method of SFAS No. 123, the Company’s net income forthe three months ended September 30, 2004 and 2003 would have decreased by$35,000 and $28,000, respectively. Basic and diluted earnings per share would have decreased by $0.01 forthe three months ended September 30, 2004.  Basic and diluted loss per share would have increased by $0.01 for thethree months ended September 30, 2003. Had compensation cost for the options granted been determined based onthe fair value at the grant dates for awards consistent with the method of SFASNo. 123, the Company’s net income for the nine months ended September 30, 2004and 2003 would have decreased by $102,000 and $93,000 respectively.  Basic earnings per share would havedecreased by $0.03 for the nine months ended September 30, 2004 and dilutedearnings per share would have decreased by $0.02 for the nine months endedSeptember 30, 2004.  Basic and dilutedloss per share would have increased by $0.03 for the nine months endedSeptember 30, 2003.

 

         The fair values of options grantedduring the three months ended September 30, 2004 and 2003 were estimated on thedate of grant using the Black-Scholes option-pricing model with the followingweighted-average assumptions used: 2004—no dividend yield, expected volatilityof 57%, risk-free interest rate of 4.21%, and an expected life of 10 years; 2003—nodividend yield, expected volatility of 59%, risk-free interest rate of 4.05%,and an expected life of 10 years.

 

NOTE8—COMPREHENSIVE INCOME (LOSS)

 

       Comprehensiveincome (loss) is the change in equity during a period from transactions andother events and circumstances from nonowner sources.  The accumulated balance of other comprehensive income (loss) isrequired to be displayed separately from retained earnings in the consolidatedbalance sheet.  Total comprehensiveincome (loss) was as follows:

 

10

----

 
|                                                                                |   | **Three  months ended** |           | **Nine  months ended** |           |
|-------------------------------------------------------------------------------------|--------|-------------------------|----------------|------------------------|----------------|
|                                                                                |   | **September  30,**      |           | **September  30,**     |           |
|                                                                                |   | **2004**                |           | **2003**               |           | **2004** |   | **2003** |   |
|                                                                                |   | **(in thousands)**      | ** **     |
|                                                                                |   |                    | ** **     |                   | ** **     |   | ** ** |   | ** ** |
| Net income (loss)                                                                   |   | $                       | 872            |                   | $              | 292 |   | $ | 1,508 |   | $ | (130 | ) |
|                                                                                |   |                    |           |                   |           |   |   |   |   |
| Other  comprehensive income (loss) before tax, and unrealized losses on securities: |   |                    |           |                   |  

  |   |    |   |  

  |
| Unrealized gain (loss) on interst rate swaps used in cash flow hedges               |   | 1,017                   |  

  | —                 |  

  | 1,017 |    | — |   |
| Unrealized gain (loss) on securities available for sale                             |   | 261                     |           | (62                    | )              | (85 | ) | (282 | ) |
|                                                                                |   |                    |           |                   |           |   |   |   |   |
| Other comprehensive income (loss), before tax                                       |   | 1,278                   |           | (62                    | )              | 932 |   | (282 | ) |
|                                                                                |   |                    |           |                   |           |   |   |   |   |
| Income tax benefit (expense) related to items of other comprehensive  income        |   | (529                    | )              | 26                     |           | (387 | ) | 117 |   |
| Other comprehensive income (loss)                                                   |   | 749                     |           | (36                    | )              | 545 |   | (165 | ) |
| Total comprehensive income (loss)                                                   |   | $                       | 1,621          |                   | $              | 256 |   | $ | 2,053 |   | $ | (295 | ) |
|                                                                                     |        |                         |                |                        |                |  |  |  |  |  |  |  |  |  |  |

 

NOTE9—JUNIOR SUBORDINATED DEFERRABLE INTEREST DEBENTURES

 

         In 2001, National Mercantile, throughNational Mercantile Capital Trust I (the “Trust”), issued 15,000 of 10.25%fixed-rate preferred securities due July 25, 2031 (the “Trust PreferredSecurities”), with a liquidation amount of $1,000 per Trust Preferred Securityand an aggregate liquidation amount of $15.0 million.  The Trust PreferredSecurities represent undivided beneficial interests in the assets of the Trustand are guaranteed by National Mercantile only with respect to distributionsand payments upon liquidation, redemption and otherwise pursuant to the termsof a guarantee agreement.

 

         The primary assets of the Trust are$15.5 million aggregate principal amount of National Mercantile’s 10.25%fixed-rate junior subordinated deferrable interest debentures due July 25,2031, (the “Junior Subordinated Debentures”) that pay interest each January 25and July 25.  The interest isdeferrable, at National Mercantile’s option, for a period up to ten consecutivesemi-annual payments, but in any event not beyond June 25, 2031.  The debentures are redeemable, in whole orin part, at National Mercantile’s option on or after five years from issuanceat declining premiums to maturity.

 

                The Company adopted FASBInterpretation No. 46, Consolidation of Variable Interest Entities (FIN 46) asof July 1, 2003 resulting in the deconsolidation of the Trust. Accordingly, theJunior Subordinated Debentures have been classified in liabilities at September30, 2004 and the related interest was classified as interest expense for thethree and nine months then 

 

 

11

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ended.  For dates and periods prior to the adoptionof FIN 46, the Trust Preferred Securities, net of the cost of issuance, wererecorded as a minority interest and the related interest was recorded as aminority interest in the Company’s income.

 

NOTE10—DERIVATIVE FINANCIAL INSTRUMENTS

 

         In January 2003, National Mercantileentered into an interest rate swap agreement pursuant to which it exchanged afixed rate payment obligation of 10.25% on a notional principal amount of $15.0million for a floating rate interest based on the six-month London InterBankOffered Rate plus 458 basis points for a 29-year period ending July 25,2031.  The interest rate swap agreementresults in National Mercantile paying or receiving the difference between the fixedand floating rates at specified intervals calculated on the notionalamounts.  The differential paid orreceived on the interest rate swap is recognized as an adjustment to interestexpense.  At September 30, 2004,National Mercantile was paying an interest rate of 5.75% under the terms of theswap.  The counter party to the swap hasthe option to call the swap under a declining premium schedule beginning July2006.  The Company is hedging against adecline in rates in its portfolio of adjustable rate loans receivable.

 

         The interest rate swap reduces the costof the 10.25% fixed-rate Junior Subordinated Debentures in a low interest rateenvironment.  The Company does notutilize derivatives for speculative purposes. Under Statement of Financial Accounting Standards No. 133 this swaptransaction is designated as a fair value hedge.  Accordingly, the ineffective portion of the change in the fairvalue of the swap transaction is recorded each period in current income.  The terms of the swap are symmetrical withthe terms of the Junior Subordinated Debentures, including the payment deferralterms, and considered highly effective in offsetting changes in fair value ofthe Junior Subordinated Debentures.  An$671,000 increase in the fair value of the swap was recorded in income for thethree-month period ended September 30, 2004 with an offsetting charge toearnings to reflect a similar decrease in the fair value of the JuniorSubordinated Debentures.   Noineffectiveness was recorded to current earnings related to the interest rateswap.

 

         The terms of the swap require NationalMercantile to provide collateral to support its contract obligations and variesbased upon the swap contract value.  AtSeptember 30, 2004, $1.3 million in securities were pledged as collateral.

 

         On July 1, 2004, the Banks entered intointerest rate swap agreements in which they exchanged an adjustable rateinterest based on the prime rate lending index for a fixed rate payment of6.925% on an aggregate notional principal amount beginning at $50.0 million fora 4-year period, declining to $30.0 million for the fifth year and $10.0million for the sixth year with a final maturity of June 30, 2010.  The interest rate swap agreement results inthe Banks paying or receiving the difference between the fixed and floatingrates at monthly intervals calculated on the notional amounts.  The differential paid or received on the 

 

 

12

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interestrate swap has been recognized as an adjustment to interest income.  At September 30, 2004, the Banks were payingan interest rate of 4.75% under the terms of the swap.

 

         These interest rate swaps reduce thecurrent asset sensitivity of the Company’s balance sheet moderating thepotential negative impact on earnings in the event of declining interestrates.  The Company does not utilizederivatives for speculative purposes. Under Statement of Financial Accounting Standards No. 133 these swaptransactions have been designated as cash flow hedges.  Accordingly, the change in fair value of theswaps is recorded each period as other comprehensive income and any ineffectiveportion of the change in the fair value is recorded in current income.  The Company has a large portion of its loanportfolio that adjusts to changes in the prime rate lending index and thereforethe swaps are currently considered highly effective in offsetting changes inthe cash flows of the loan portfolio.

 

NOTE11—CONVERSION OF PREFERRED STOCK

 

         During the nine months ended September 30, 2004, 63,312shares of Series A non-cumulative convertible perpetual preferredstock were converted into 126,624 shares of common stock.

 

 

NOTE12—RECLASSIFICATIONS

 

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

 

 

***Item 2.******                     ******MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION 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”) (collectively, “theBanks”).  National Mercantile’sprincipal assets are the capital stock of Mercantile and South Bay.

 

In July 2001, National Mercantile formedNational Mercantile Capital Trust (the “Trust”) as a Delaware statutorybusiness trust formed for the exclusive purpose of issuing and selling trustpreferred securities (the “Trust Preferred Securities”).  The Trust issued those securities andutilized the proceeds to purchase from National Mercantile, its juniorsubordinated deferrable interest debentures (the “Junior SubordinatedDebentures”).  Through June 30, 2003,the Company’s financial statements reflected the Trust as a consolidatedsubsidiary, with the effect that the Trust Preferred Securities of the Trustreflected on the 

 

 

13

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balancesheet as mezzanine equity and payments on the Trust Preferred Securities wereset forth as minority interest in the Company’s income of the guaranteedpreferred beneficial interest in the Junior Subordinated Debentures.

 

       The Company implemented FIN 46 effectiveJuly 1, 2003 with the effect that since that date the Trust has not been aconsolidated subsidiary of the Company for financial reporting purposes.  As a result: (i) the Company’s balancesheets as of dates on or after July 1, 2003 no longer reflect the TrustPreferred Securities as mezzanine equity but instead reflect the Junior SubordinatedDebentures as liabilities, and (ii) the Company’s statements of operationsincorporating periods on or after July 1, 2003, reflect from July 1, 2003forward interest payments on the Junior Subordinated Debentures as interestexpense and do not reflect payments on the Trust Preferred Securities as aminority interest in the Company’s income of the guaranteed preferredbeneficial interest in the Company’s Junior Subordinated Debentures.  As discussed below, this has a significanteffect on comparisons of net interest income between periods on and after July1, 2003.

 

 

**RESULTS OF OPERATIONS**

 

The Company recorded net income of$872,000, or $0.30 basic earnings per share and $0.19 diluted earnings pershare, for the three months ended September 30, 2004 compared to net income of$292,000, or $0.11 basic earnings per share and $0.07 diluted earnings pershare, for the same period of 2003.  The increase in net income for the 2004 period was primarily due to a$1.3 million increase in net interest income resulting from interest rateswaps, increases in the prime rate lending index, a greater volume of interestearning assets, particularly higher yielding loans receivable and securitiesavailable-for-sale, and a favorable change in earning asset and fundingliability composition.

 

The Company recorded net income of $1.5million, or $0.52 basic earnings per share and $0.33 diluted earnings pershare, for the nine months ended September 30, 2004 compared to a net loss of$130,000, or $0.05 basic and diluted loss per share, for the same period of 2003.   The increase in net income for the 2004period was due to a $1.2 million increase in net interest income resulting fromthe Banks’ interest rate swaps, increases in the prime rate lending index and agreater volume of higher yielding earning assets, as well as a $265,000decrease in interest expense resulting from lower deposit interest rates and afavorable change in deposit mix. Additionally, 2004 net income benefited significantly from a $1.1million decrease in provision for credit losses.  These positive changes were partially offset by a $128,000increase in other operating expenses.

 

Return on average assets during the thirdquarter and first nine months of 2004 was 0.88% and 0.39%, respectively,compared to 0.31% and a negative 0.05% during the third quarter and first ninemonths of 2003, respectively. Return on 

 

14

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averageequity during the third quarter and first nine months of 2004 was 10.47% and4.53%, respectively, compared to 3.72% and a negative 0.55% during the thirdquarter and first nine months of 2003, respectively.

 

NETINTEREST INCOME

 

         Net interest income before theprovision for credit losses increased $1.3 million for the three months endedSeptember 30, 2004 compared to the same quarter of 2003 due to a $1.2 millionincrease in total interest income.  Loaninterest income increased $1.2 million due to $40.3 million greater averagevolume of loans receivable and a 74 basis point increase in yield, resultingprimarily from interest rate swaps and increases in the prime rate lendingindex.  The increase in loans receivableis due to the added business development staff, the funding of previouslyapproved construction loans and stronger new construction and commercial realestate loan demand.   On July 1, 2004,the Banks entered into interest rate swap agreements in which they exchanged anadjustable rate interest based on the prime rate lending index for a fixed ratepayment of 6.925% on an aggregate notional principal amount of $50.0 million(see Note 10 Derivative Financial Instruments of the Consolidated FinancialStatements for details of the swap terms). The interest rate swaps contributed 42 basis points to the increase inloan yield.  During the third quarter of2004, the Federal Reserve Bank increased interest rates 25 basis points onthree occasions after a prolonged period of accommodative monetary policy inresponse to signs of stronger expansion of the economy.  Approximately 70% of the $303.8 millionloans receivable have adjustable interest rates; accordingly, rising interestrates positively affects interest income partially offset by greater paymentsfor the $50 million interest rate swaps.

 

         Interest income from securitiesavailable-for-sale increased $134,000 during the third quarter 2004 compared tothird quarter 2003 despite a 29 basis point decline in yield due to $20.8million greater average volume.  Thedecline in the yield from securities available-for-sale was due to lower yieldson the newly purchased securities and the maturity or pay down ofhigher-yielding securities in the portfolio. The growth in securities was a result of the redeployment of loweryielding federal funds sold, which averaged $41.7 million less than the 2003period.  The decline in average federalfunds sold more than offset a 43 basis point increase in yield resulting in an$87,000 decline in interest income on federal funds sold in the 2004 period.

 

         Overall, interest-earning assets were$23.3 million greater during the third quarter 2004 than third quarter 2003 andthe higher yields and favorable change in composition to higher-yielding assetsresulted in a 105 basis point increase in weighted average yield oninterest-earning assets.

 

         Interest expense decreased $31,000 forthe three months ended September 30, 2004, despite a $19.4 million increase inaverage interest-bearing liabilities, due to a lower cost of funds and afavorable change in deposit composition. Average 

 

 

15

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interest-bearingdeposits were $4.5 million greater than the third quarter 2003; however,interest expense on deposits decreased $75,000 due to a 17 basis point declinein weighted average cost.  Relativelylow costing interest-bearing demand deposits and money market and savingsdeposits averaged $2.0 million and $9.3 million greater, respectively, in the2004 period compared to the 2003 period. Relatively high costing time certificates of deposit averaged $6.8million less during the third quarter 2004 than the same period in 2003.  This favorable change in deposit compositionis due to a combination of emphasis on developing business banking, whichresults in greater volumes of transactional deposits, with limited increases inpricing, particularly at South Bay, on typically retail time certificates ofdeposit resulting in some runoff at maturity. The cost of time certificates of deposit declined 39 basis points due tothe maturity of higher yielding deposits and repricing during the sustained lowinterest rate environment.  While marketrates of interest increased during the third quarter of 2004, the cost ofinterest-bearing demand deposits and money market and savings deposits declined4 basis points and 1 basis point, respectively, compared to the third quarterof 2003.  The Company elected togenerally hold deposit rates stable and fund earning asset growth mostly withrelatively inexpensive overnight other borrowings.  Other borrowings during the third quarter 2004 averaged $23.0million, or $15.5 million greater than the same period in 2003.  The cost of other borrowings was 1.82% and4.71% for the third quarters 2004 and 2003, respectively, representing adecline of 289 basis points in 2004.  Ina sustained rising interest rate environment, increases in deposit interestrates will be required to prevent net deposit withdrawals.  Noninterest-bearing demand deposits wererelatively stable, with a $494,000 increase in average volume in the thirdquarter 2004 compared to 2003.

 

         The Company altered its liquiditystrategy during the third quarter of 2004, maintaining a significantly lowerlevel of short-term assets, primarily federal funds sold, and relying onovernight other borrowings, against pledged loans and securities, to fund loangrowth and deposit outflows.  Liquiditywas supplemented with brokered time certificates of deposit.

 

         The net yield on interest earningassets increased 122 basis points from 4.11% during the third quarter in 2003to the third quarter in 2004.

 

         Net interest income before theprovision for credit losses increased $1.2 million for the nine months endedSeptember 30, 2004 compared to the same period of 2003 due to the inclusion of$713,000 interest on the Junior Subordinated Debentures in the 2004 compared to  $228,000 in 2003, due to an accountingchange in the third quarter of 2003.

 

         Interest income increased due to a0.16% increase in the weighted average yield on interest earning assets alongwith a $11.9 million increase in average interest earning assets.  The increase in the weighted average yieldon interest earning assets was due to an increase in market interest rates,resulting in a repricing of adjustable rate assets (primarily loans) and lower 

 

 

16

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yieldson renewed loans and newly originated or purchased assets.   The yield on loans receivable increased 3basis points for the 2004 period compared to 2003 and loans receivable averaged$12.5 million more in the first nine months of 2004 compared to the same periodin 2003, due to a higher volume of loans in the third quarter of 2004.  The increase in interest income wasmoderated by a change in the composition of earning assets.  The average volume of lower-yielding federalfunds sold and securities purchased under agreements to resell declined $25.2million for the nine months ended September 30, 2004 while the average volumesof higher- yielding securities available-for-sale and securitiesheld-to-maturity increased $17.6 million and $3.4 million, respectively.

 

         Interest expense decreased due to a0.28% decline in the weighted average rates on interest-bearing liabilities,which more than offset a $16.2 million increase in average interest-bearingliabilities. The reduction in the weighted average rate was due to: (i) adecline in market interest rates and (ii) an increase in lower-cost demand,savings and money market deposits and reduction in higher-cost certificates ofdeposit.  This was offset in part by theinclusion of interest on the higher cost Junior Subordinated Debentures asinterest expense.  Interest-bearingdemand, and money market and savings deposits increased $3.0 million and $11.5million, respectively, as a result of the additional resources expended todevelop business banking.  Timecertificates of deposit decreased $14.2 million due to more aggressive pricingpractices.

 

         The following table presents thecomponents of net interest income for the three months ended September 30, 2004and 2003.

 

 

17

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** **

**Average Balance Sheet and**

**Analysis of Net Interest Income**

 
| ** **                                                                                                               | ** ** | **Three months ended**     | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                                               | ** ** | **September 30, 2004**     | ** ** | **September 30, 2003** | ** ** |
| ** **                                                                                                               | ** ** | **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                                                  |       | $                          | 1,558      |   | 5 |   | 1.28 | % | $ | 43,228 |   | $ | 92 |   | 0.84 | % |
| Due from banks-interest bearing                                                                                          |       | 2,728                      |       | 12 |   | 1.75 | % | 363 |   | 5 |   | 5.39 | % |
| Securities available-for-sale                                                                                            |       | 49,183                     |       | 365 |   | 2.97 | % | 28,341 |   | 231 |   | 3.26 | % |
| Securities held-to-maturity                                                                                              |       | 3,927                      |       | 38 |   | 3.87 | % | 2,395 |   | 20 |   | 3.34 | % |
| Loans receivable (1) (2)                                                                                                 |       | 297,602                    |       | 5,067 |   | 6.77 | % | 257,328 |   | 3,914 |   | 6.03 | % |
| Total interest earning assets                                                                                            |       | 354,998                    |       | 5,487 |   | 6.15 | % | 331,655 |   | 4,262 |   | 5.10 | % |
|                                                                                                                     |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest earning assets:                                                                                              |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks - demand                                                                                         |       | 22,314                     |       |   |   |   |   | 22,764 |   |   |   |   |   |
| Other assets                                                                                                             |       | 21,694                     |       |   |   |   |   | 22,032 |   |   |   |   |   |
| Allowance for credit losses and net  unrealized gain on sales of securities available-for-sale                           |       | (3,891                     | )          |   |   |   |   | (3,480 | ) |   |   |   |   |
| Total assets                                                                                                             |       | $                          | 395,115    |   |   |   |   |   | $ | 372,971 |   |   |   |   |   |
|                                                                                                                     |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Liabilities and shareholders’ equity:                                                                               |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing deposits:                                                                                               |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Demand                                                                                                                   |       | $                          | 31,827     |   | 19 |   | 0.24 | % | $ | 29,781 |   | 21 |   | 0.28 | % |
| Money market and savings                                                                                                 |       | 112,114                    |       | 195 |   | 0.69 | % | 102,838 |   | 181 |   | 0.70 | % |
| Time certificates of deposit:                                                                                            |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| $100,000 or more                                                                                                         |       | 25,371                     |       | 93 |   | 1.46 | % | 27,504 |   | 163 |   | 2.35 | % |
| Under $100,000                                                                                                           |       | 27,479                     |       | 121 |   | 1.75 | % | 32,158 |   | 138 |   | 1.70 | % |
| Total time certificates of deposit                                                                                       |       | 52,850                     |       | 214 |   | 1.61 | % | 59,662 |   | 301 |   | 2.00 | % |
| Total interest-bearing deposits                                                                                          |       | 196,791                    |       | 428 |   | 0.87 | % | 192,281 |   | 503 |   | 1.04 | % |
| Other borrowings                                                                                                         |       | 22,982                     |       | 105 |   | 1.82 | % | 7,500 |   | 89 |   | 4.71 | % |
| Junior subordinated debentures                                                                                           |       | 15,464                     |       | 259 |   | 6.66 | % | 15,464 |   | 228 |   | 5.85 | % |
| Federal funds purchased and securities sold  under agreements to repurchase                                              |       | —                     |       | — |   | 0.00 | % | 606 |   | 3 |   | 1.96 | % |
| Total interest-bearing liabilities                                                                                       |       | 235,237                    |       | 792 |   | 1.34 | % | 215,851 |   | 823 |   | 1.51 | % |
|                                                                                                                     |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing liabilities:                                                                                         |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing demand deposits                                                                                      |       | 125,857                    |       |   |   |   |   | 125,363 |   |   |   |   |   |
| Other liabilities                                                                                                        |       | 969                        |       |   |   |   |   | 620 |   |   |   |   |   |
| Guaranteed preferred beneficial interests in  the Company’s junior subordinated deferrable interest debentures, net |       | —                     |       |   |   |   |   | — |   |   |   |   |   |
| Shareholders’ equity                                                                                                |       | 33,052                     |       |   |   |   |   | 31,137 |   |   |   |   |   |
| Total liabilities and shareholders’ equity                                                                          |       | $                          | 395,115    |   |   |   |   |   | $ | 372,971 |   |   |   |   |   |
|                                                                                                                     |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income (spread)                                                                                             |       |                       |       | $ | 4,695 |   | 4.81 | % |   |   | $ | 3,439 |   | 3.59 | % |
|                                                                                                                     |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Net yield on interest earning assets (2)                                                                            |       |                       |       |   |   | 5.26 | % |   |   |   |   | 4.11 | % |
|                                                                                                                          |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          The average balance of nonperforming loans has been included in loansreceivable.

(2)          Yields and amounts earned on loans receivable include loan fees of$484,000 and $239,000 for the three months ended September 30, 2004 and 2003,respectively.

 

18

----

 

The following table presents the componentsof net interest income for the nine months ended September 30, 2004 and 2003.

 

**Average Balance Sheet and**

**Analysis of Net Interest Income**

 
| ** **                                                                                                               | ** ** | **Nine months ended**      | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                                               | ** ** | **September 30, 2004**     | ** ** | **September 30, 2003** | ** ** |
| ** **                                                                                                               | ** ** | **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                                                  |       | $                          | 7,823      |   | 59 |   | 1.01 | % | $ | 32,974 |   | 268 |   | 1.09 | % |
| Due from banks-interest bearing                                                                                          |       | 3,835                      |       | 40 |   | 1.39 | % | 338 |   | 5 |   | 1.95 | % |
| Securities available-for-sale                                                                                            |       | 42,889                     |       | 955 |   | 2.97 | % | 25,296 |   | 640 |   | 3.37 | % |
| Securities held-to-maturity                                                                                              |       | 4,226                      |       | 118 |   | 3.72 | % | 807 |   | 20 |   | 3.30 | % |
| Loans receivable (1) (2)                                                                                                 |       | 276,845                    |       | 12,772 |   | 6.16 | % | 264,345 |   | 12,121 |   | 6.13 | % |
| Total interest earning assets                                                                                            |       | 335,618                    |       | 13,944 |   | 5.55 | % | 323,760 |   | 13,054 |   | 5.39 | % |
|                                                                                                                     |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest earning assets:                                                                                              |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks - demand                                                                                         |       | 22,822                     |       |   |   |   |   | 21,884 |   |   |   |   |   |
| Other assets                                                                                                             |       | 21,661                     |       |   |   |   |   | 21,574 |   |   |   |   |   |
| Allowance for credit losses and net  unrealized gain on sales of securities available-for-sale                           |       | (3,705                     | )          |   |   |   |   | (4,161 | ) |   |   |   |   |
| Total assets                                                                                                             |       | $                          | 376,396    |   |   |   |   |   | $ | 363,057 |   |   |   |   |   |
|                                                                                                                     |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Liabilities and shareholders’ equity:                                                                               |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing deposits:                                                                                               |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Demand                                                                                                                   |       | $                          | 31,395     |   | 55 |   | 0.23 | % | $ | 28,349 |   | 110 |   | 0.52 | % |
| Money market and savings                                                                                                 |       | 108,580                    |       | 541 |   | 0.67 | % | 97,077 |   | 736 |   | 1.01 | % |
| Time certificates of deposit:                                                                                            |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| $100,000 or more                                                                                                         |       | 23,867                     |       | 250 |   | 1.40 | % | 30,172 |   | 429 |   | 1.90 | % |
| Under $100,000                                                                                                           |       | 26,611                     |       | 339 |   | 1.70 | % | 34,526 |   | 657 |   | 2.54 | % |
| Total time certificates of deposit                                                                                       |       | 50,478                     |       | 589 |   | 1.56 | % | 64,698 |   | 1,086 |   | 2.24 | % |
| Total interest-bearing deposits                                                                                          |       | 190,453                    |       | 1,185 |   | 0.83 | % | 190,124 |   | 1,932 |   | 1.36 | % |
| Other borrowings                                                                                                         |       | 13,703                     |       | 277 |   | 2.70 | % | 7,500 |   | 267 |   | 4.76 | % |
| Junior subordinated debentures                                                                                           |       | 15,464                     |       | 713 |   | 6.16 | % | 5,155 |   | 228 |   | 5.91 | % |
| Federal funds purchased and securities sold  under agreements to repurchase                                              |       | 94                         |       | 1 |   | 1.42 | % | 686 |   | 14 |   | 2.73 | % |
| Total interest-bearing liabilities                                                                                       |       | 219,714                    |       | 2,176 |   | 1.32 | % | 203,465 |   | 2,441 |   | 1.60 | % |
|                                                                                                                     |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing liabilities:                                                                                         |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing demand deposits                                                                                      |       | 123,272                    |       |   |   |   |   | 117,791 |   |   |   |   |   |
| Other liabilities                                                                                                        |       | 888                        |       |   |   |   |   | 743 |   |   |   |   |   |
| Guaranteed preferred beneficial interests in  the Company’s junior subordinated deferrable interest debentures, net |       | —                     |       |   |   |   |   | 9,689 |   |   |   |   |   |
| Shareholders’ equity                                                                                                |       | 32,522                     |       |   |   |   |   | 31,369 |   |   |   |   |   |
| Total liabilities and shareholders’ equity                                                                          |       | $                          | 376,396    |   |   |   |   |   | $ | 363,057 |   |   |   |   |   |
|                                                                                                                     |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income (spread)                                                                                             |       |                       |       | $ | 11,768 |   | 4.23 | % |   |   | $ | 10,613 |   | 3.79 | % |
|                                                                                                                     |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Net yield on interest earning assets (2)                                                                                 |       |                       |       |   |   | 4.68 | % |   |   |   |   | 4.38 | % |
|                                                                                                                          |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          The average balance of nonperforming loans has been included in loansreceivable.

(2)          Yields and amounts earned on loans receivable include loan feesof $1,052,000 and $656,000 for the three months ended September 30, 2004 and2003, respectively.

 

19

----

 

 

The following table sets forth, for theperiods indicated, the changes in interest earned and interest paid resultingfrom changes in volume and changes in rates. Average balances in all categories in each reported period were used inthe volume computations.  Average yieldsand rates in each reported period were used in rate computations.  

 

**Increase (Decrease) in InterestIncome/Expense Due to Change in**

**Average Volume and Average Rate(1)**

 
| ** **                                                                  | ** ** | **Nine months ended September 30, 2004 vs 2003** | ** ** |
|-----------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                  | ** ** | **Increase (decrease) due to:**                  | ** ** | **Net**

**Increase** | ** ** |
| ** **                                                                  | ** ** | **Volume**                                       | ** ** | **Rate** | ** ** | **(Decrease)** | ** ** |
| Interest Income:                                                            |       |                                             |       |   |   |   |   |
| Federal funds sold and securities purchased  under agreement to resell.     |       | $                                                | (204       | ) | $ | (5 | ) | $ | (209 | ) |
| Interest-bearing deposits with other  financial institutions                |       | 51                                               |       | (16 | ) | 35 |   |
| Securities available-for-sale                                               |       | 445                                              |       | (130 | ) | 315 |   |
| Securities held-to-maturity                                                 |       | 85                                               |       | 13 |   | 98 |   |
| Loans receivable (2)                                                        |       | 585                                              |       | 66 |   | 651 |   |
| Total interest-earning assets                                               |       | 962                                              |       | (72 | ) | 890 |   |
|                                                                        |       |                                             |       |   |   |   |   |
| Interest Expense:                                                           |       |                                             |       |   |   |   |   |
| Interest-bearing deposits:                                                  |       |                                             |       |   |   |   |   |
| Demand                                                                      |       | $                                                | 12         |   | $ | (67 | ) | $ | (55 | ) |
| Money market and savings                                                    |       | 88                                               |       | (283 | ) | (195 | ) |
| Time certificates of deposit:                                               |       |                                             |       |   |   |   |   |
| $100,000 or more                                                            |       | (90                                              | )          | (89 | ) | (179 | ) |
| Under $100,000                                                              |       | (150                                             | )          | (168 | ) | (318 | ) |
| Total time certificates of deposit                                          |       | (240                                             | )          | (257 | ) | (497 | ) |
| Total interest-bearing deposits                                             |       | (140                                             | )          | (607 | ) | (747 | ) |
| Other borrowings                                                            |       | 221                                              |       | (211 | ) | 10 |   |
| Junior subordinated debentures                                              |       | 457                                              |       | 28 |   | 485 |   |
| Federal funds purchased and securities sold  under agreements to repurchase |       | (12                                              | )          | (1 | ) | (13 | ) |
| Total interest-bearing liabilities                                          |       | 526                                              |       | (791 | ) | (265 | ) |
|                                                                        |       |                                             |       |   |   |   |   |
| Net interest income                                                         |       | $                                                | 436        |   | $ | 719 |   | $ | 1,155 |   |

----

(1)          The change in interest income or interest expense that is attributableto both changes in average balance and average rate has been allocated to thechanges due to (i) average balance and (ii) average rate in proportion to therelationship of the absolute amounts of changes in each.

(2)          Table does not include interest income that would have been earned onnonaccrual loans.

 

20

----

 

PROVISIONFOR CREDIT LOSSES

 

The Company recorded a $120,000 provisionfor credit losses for the three months and nine months ended September 30, 2004compared to provisions of $10,000 and $1.3 million for the three months andnine months ended September 30, 2003, respectively.  The provision in the third quarter of 2004was primarily due to the growth in loans receivable.  The decrease in provisions for credit lossesfor the nine months ended September 30, 2004 compared to the nine months endedSeptember 30, 2003 was due to recoveries of loans previously charged off andthe current adequacy of the allowance for credit losses based upon ouranalysis.  See Note 4 of Notes toConsolidated Financial Statements.

 

OTHEROPERATING INCOME

 

Other operating income decreased to$317,000 during the third quarter of 2004 from $397,000 during the thirdquarter of 2003 primarily due to a $95,000 net loss on sale ofsecurities-available-for sale partially offset by an $18,000 increase indeposit-related and other customer service income due to increased fees and newproduct introduction.

 

Other operating income increased to $1.2million during the nine months ended September 30, 2004 from $1.1 millionduring the nine months ended September 30, 2003 due to an increase indeposit-related and other customer service income.  The increase was partially offset by a$176,000 decrease in net gain on sale of securities available-for-sale anddecline in investment services income.

 

Net gains on sales of securities aregenerated primarily in declining interest rate environments.   Accordingly, gains or losses from sales ofsecurities may fluctuate significantly from period to period, and the resultsin any period are not necessarily indicative of the results  which may be obtained in future periods.

 

OTHER OPERATING EXPENSES

 

Other operating expensesincreased to $3.4 million for the three months ended September 30, 2004compared to $3.3 million for the same period of 2003. Variances withinoperating expenses were reflected as follows: (i) salaries and related benefitsexpense increased $92,000 or 5.1%; (ii) net occupancy expense decreased $63,000or 18.9%; (iii) premise and equipment expense decreased $21,000 or 18.8%; (iv)client services expense increased $27,000 or 20.9%; (v) computer dataprocessing expense decreased $25,000 or 9.6%; (vi) legal services expense decreased $69,000 or 56.6%;  (vii) other 

 

21

----

 

professional services expense increased $20,000 or 9.7%; and (viii)promotional and other expenses increased $115,000 or 280.5%.

 

Other operating expensesincreased to $10.2 million for the nine months ended September 30, 2004compared to $10.1 million for the same period in 2003. Variances withinoperating expenses were reflected as follows; (i) salaries and related benefitsexpense increased $177,000 or 3.2%; (ii) net occupancy expense decreased$121,000 or 12.0%; (iii) premise and equipment expense increased $43,000 or12.4%; (iv) insurance and regulatory assessments increased $35,000, or 12.0%;(v) legal services expense decreased $148,000 or 38.7%; (vii) retirement ofpremises and equipment increased $43,000 and (viii) promotional and otherexpenses increased $112,000 or 42.6%.

 

The increase in salary andrelated expense is primarily due to the addition of business development staffand increased commission expense. The decrease in occupancy expense was due toa decrease in rent expense from the move of the corporate headquarters inJanuary 2004. The decrease in premise and equipment expense is due to lessdepreciation of furniture and equipment. Client services expenses increased due to increased data processing andmessenger services for clients.  Legalexpenses decreased for the collection of loans due to fewer past due loans andfewer other real estate owned properties.   Promotion and other expenses increased due to operating lossesincreases.

 

MINORITYINTEREST IN THE COMPANY’S INCOME

 

The minority interest in the Company’sincome of the guaranteed beneficial interest in the Company’s JuniorSubordinated Debentures was $713,000 for the nine months ended September 30,2003.  As a result of thereclassification pursuant to FIN 46 effective July 1, 2003, no such minorityinterest expense was recorded for the nine months ended September 30, 2004.

 

 

***BALANCE SHEET ANALYSIS***

 

 

INVESTMENT SECURITIES

 

The following comparative period-end table sets forth certaininformation concerning the estimated fair values and

unrealized gains and losses of securities available-for-sale andsecurities held-to-maturity.

 

22

----

 

**Estimated Fair Values of andUnrealized**

**Gains and Losses on Securities**

 
| ** **                                                                 | ** ** | **September 30, 2004**             | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                 | ** ** | **Total**

**amortized**

**cost** | ** ** | **Gross**

**unrealized**

**gains** | ** ** | **Gross**

**unrealized**

**loss** | ** ** | **Estimated**

**fair**

**value** | ** ** |
| ** **                                                                 | ** ** | **(Dollars in thousands)**         | ** ** |
| **Available-for-Sale:**                                                    |       |                               |       |   |   |   |   |   |   |
| U.S. Treasury securities                                                   |       | $                                  | 701        |   | $ | — |   | $ | 1 |   | $ | 700 |   |
| GNMA-issued/guaranteed mortgage pass  through certificates.                |       | 194                                |       | 8 |   | — |   | 202 |   |
| Other U.S. Government and federal agency  securities                       |       | 30,072                             |       | 30 |   | 9 |   | 30,093 |   |
| FHLMC/FNMA-issued mortgage pass through  certificates                      |       | 3,704                              |       | 114 |   | — |   | 3,818 |   |
| CMO’s and REMIC’s issued by U.S.  government-sponsored agencies. |       | 41                                 |       | — |   | — |   | 41 |   |
| Mutual funds                                                               |       | 5,405                              |       | — |   | 108 |   | 5,297 |   |
| Privately issued corporate bonds, CMO and  REMIC securities                |       | 868                                |       | 2 |   | — |   | 870 |   |
|                                                                       |       | $                                  | 40,985     |   | $ | 154 |   | $ | 118 |   | $ | 41,021 |   |
|                                                                       |       |                               |       |   |   |   |   |   |   |
| FRB and other equity stocks                                                |       | $                                  | 2,956      |   | — |   | — |   | $ | 2,956 |   |

 
| ** **                                            | ** ** | **September 30, 2004**             | ** ** |
|-------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                            | ** ** | **Total**

**amortized**

**cost** | ** ** | **Gross**

**unrealized**

**gains** | ** ** | **Gross**

**unrealized**

**loss** | ** ** | **Estimated**

**fair**

**value** | ** ** |
| ** **                                            | ** ** | **(Dollars in thousands)**         | ** ** |
| **Held-to-Maturity:**                                 |       |                               |       |   |   |   |   |   |   |
| FHLMC/FNMA-issued mortgage pass through  certificates |       | $                                  | 3,776      |   | $ | 58 |   | $ | — |   | $ | 3,834 |   |
|                                                  |       | $                                  | 3,776      |   | $ | 58 |   | $ | — |   | $ | 3,834 |   |

 
| ** **                                                                | ** ** | **December 31, 2003**              | ** ** |
|---------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                | ** ** | **Total**

**amortized**

**cost** | ** ** | **Gross**

**unrealized**

**gains** | ** ** | **Gross**

**unrealized**

**loss** | ** ** | **Estimated**

**fair**

**value** | ** ** |
| ** **                                                                | ** ** | **(Dollars in thousands)**         | ** ** |
| **Available-For-Sale:**                                                   |       |                               |       |   |   |   |   |   |   |
| U.S. Treasury securities                                                  |       | $                                  | 600        |   | $ | — |   | $ | 1 |   | $ | 599 |   |
| GNMA-issued/guaranteed mortgage pass  through certificates                |       | 351                                |       | 12 |   | — |   | 363 |   |
| Other U.S. government and federal agency  securities                      |       | 12,758                             |       | 45 |   | 4 |   | 12,799 |   |
| FHLMC/FNMA-issued mortgage pass through  certificates                     |       | 3,828                              |       | 161 |   | — |   | 3,989 |   |
| CMO’s and REMIC’s issued by U.S.  government-sponsored agencies |       | 56                                 |       | 1 |   | — |   | 57 |   |
| Mortgage mutual funds                                                     |       | 10,000                             |       | — |   | 98 |   | 9,902 |   |
| Privately issued corporate bonds, CMO and  REMIC securities               |       | 3,163                              |       | 5 |   | — |   | 3,168 |   |
|                                                                      |       | $                                  | 30,756     |   | $ | 224 |   | $ | 103 |   | $ | 30,877 |   |
|                                                                      |       |                               |       |   |   |   |   |   |   |
| FRB and other equity stocks                                               |       | $                                  | 1,872      |   | — |   | — |   | $ | 1,872 |   |

 
| ** **                                            | ** ** | **December 31, 2003**              | ** ** |
|-------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                            | ** ** | **Total**

**amortized**

**cost** | ** ** | **Gross**

**unrealized**

**gains** | ** ** | **Gross**

**unrealized**

**loss** | ** ** | **Estimated**

**fair**

**value** | ** ** |
| ** **                                            | ** ** | **(Dollars in thousands)**         | ** ** |
| **Held-to-Maturity:**                                 |       |                               |       |   |   |   |   |   |   |
| FHLMC/FNMA-issued mortgage pass through  certificates |       | $                                  | 4,597      |   | $ | 43 |   | $ | — |   | $ | 4,640 |   |
|                                                  |       | $                                  | 4,597      |   | $ | 43 |   | $ | — |   | $ | 4,640 |   |

 

23

----

 

As of September 30, 2004, theCompany did not hold securities of any issuer, other than U.S. governmentagencies and corporations, the aggregate book value of which exceeded 10% ofthe Company’s shareholders’ equity, except $5.3 million of an adjustable ratemortgage mutual fund in which the fund’s holdings are primarily comprised ofU.S. agency securities, agency mortgage pools and U.S. Treasury securities.

 

LOAN PORTFOLIO

 

The following comparative period-endtable sets forth certain information concerning the composition of the loanportfolio. 

 

**LoanPortfolio Composition**

 
| ** **                                                            | ** ** | **September 30,**          | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------|------------|------------------|------------|
| ** **                                                            | ** ** | **2004**                   | ** ** | **2003**         | ** ** |
| ** **                                                            | ** ** | **Amount**                 | ** ** | **Percent**      | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **                                                            | ** ** | **(Dollars in thousands)** | ** ** |
| Real estate loans:                                                    |       |                       |       |             |       |   |   |   |   |
| Secured by one to four family residential  properties                 |       | $                          | 11,134     |             | 4          | % | $ | 8,167 |   | 3 | % |
| Secured by multifamily residential properties                         |       | 12,771                     |       | 4                | %          | 13,071 |   | 5 | % |
| Secured by commercial real properties                                 |       | 142,218                    |       | 46               | %          | 132,320 |   | 52 | % |
| Real estate construction and land development                         |       | 47,784                     |       | 16               | %          | 27,210 |   | 10 | % |
| Commercial loans - secured and unsecured                              |       | 88,802                     |       | 29               | %          | 76,699 |   | 29 | % |
| Consumer installment, home equity and  unsecured loans to individuals |       | 2,033                      |       | 1                | %          | 3,510 |   | 1 | % |
| Total loans outstanding                                               |       | 304,742                    |       | 100              | %          | 260,977 |   | 100 | % |
|                                                                  |       |                       |       |             |       |   |   |   |   |
| Deferred net loan origination fees and  purchased loan discount       |       | (930                       | )          |             |       | (728 | ) |   |   |
| Loans receivable, net                                                 |       | $                          | 303,812    |             |       |   | $ | 260,249 |   |   |   |
|                                                                       |            |                            |            |                  |            |  |  |  |  |  |  |  |  |

 

24

----

 

Total loans outstanding increased by$43.6 million to $303.8 million at September 30, 2004 compared to $260.2million at December 31, 2003 due to the funding of previously originated realestate construction and land development loans as well as new originations inreal estate construction loans, real estate loans secured by commercial realproperties and commercial loans.  Due tothe nature of construction loans, the outstanding balance of newly originatedloans increases gradually during the life of the loan and repays in a lumpsum.  During the latter half of 2003 andearly part of 2004, the Company hired several seasoned lending officersresulting in increased new business development.

 

Real estate construction and landdevelopment loans increased $20.6 million from $27.2 million at December 31,2003 to $47.8 million at September 30, 2004. During this same time period, commercial loans increased $12.1 millionfrom $76.7 million to $88.8 million, real estate loans secured by commercialreal properties increased $9.9 million from $132.3 million to $142.2 millionand real estate loans secured by one to four family residential propertiesincreased $2.9 million from $8.2 million to $11.1 million.  Relatively small declines were recorded inreal estate loans secured by multifamily residential properties and consumerinstallment, home equity and unsecured loans to individuals.

 

NONPERFORMING ASSETS

 

The following comparative period-endtable sets forth certain information concerning nonperforming assets.  

 

**NonperformingAssets**

 
| ** **                                                                                                                 | ** ** | **September 30,**

**2004** | ** ** | **December 31**

**2003** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|---------------------------|------------|
| ** **                                                                                                                 | ** ** | **(Dollars in thousands)**  | ** ** |
|                                                                                                                       |       |                        |       |                      |       |
| Nonaccrual loans                                                                                                           |       | $                           | 238        |                      | $          | 438 |   |
| Troubled debt restructurings                                                                                               |       | —                      |       | —                    |       |
| Loans contractually past due ninety or more  days with respect to either principal or interest and still accruing interest |       | 5                           |       | —                    |       |
| Nonperforming loans                                                                                                        |       | 243                         |       | 438                       |       |
| Other real estate owned                                                                                                    |       | 1,043                       |       | 925                       |       |
| Other nonperforming assets                                                                                                 |       | —                      |       | —                    |       |
| Total nonperforming assets                                                                                                 |       | $                           | 1,286      |                      | $          | 1,363 |   |
|                                                                                                                       |       |                        |       |                      |       |
| Allowance for credit losses as a percent of  nonaccrual loans                                                              |       | 1617.6                      | %          | 829.9                     | %          |
| Allowance for credit losses as a percent of  nonperforming loans                                                           |       | 1584.4                      | %          | 829.9                     | %          |
| Total nonperforming assets as a percent of  loans receivable                                                               |       | 0.4                         | %          | 0.5                       | %          |
| Total nonperforming assets as a percent of  total shareholders’ equity                                                |       | 3.8                         | %          | 4.3                       | %          |

 

25

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Nonaccrual loans decreased $200,000 fromDecember 31, 2003 to September 30, 2004 due primarily to collection ofnonaccrual loans and loan charge offs. Other real estate owned (OREO) increased $118,000 from December 31, 2003to September 30, 2004 due to capitalization of expenditures for improvements onexisting OREO.  Nonaccrual and impairedloans are accounted for under the Company’s policy, which is in accordance withFinancial Accounting Standards No. 114 Accounting by Creditors for Impairmentof a Loan.

 

 

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 advisory firm, performs a periodic risk and creditanalysis, the results of which are reported to the Board of Directors.

 

No loans were charged off during thethird quarter of 2004.  Loans charged offduring the nine months ended September 30, 2004 were $35,000.  This compares to loans charged off of $7,000and $2.9 million during the third quarter and first nine months of 2003,respectively.  Recoveries of loanspreviously charged off were $39,000 and $130,000 during the third quarter andfirst nine months of 2004, respectively, compared to $133,000 and $327,000during the third quarter and first nine months of 2003, respectively.  See Note 4 of Notes to Consolidated FinancialStatements.

 

Credit quality is affected by manyfactors beyond the control of the Company, including local and nationaleconomies, and facts may exist which are not known to the Company thatadversely affect the likelihood of repayment of various loans in the loan portfolioand realization of collateral upon a default. Accordingly, no assurance can begiven that the Company will not sustain loan losses materially in excess of theallowance for credit losses. In addition, the Office of the Comptroller of theCurrency (“OCC”), as an integral part of its examination process, periodicallyreviews the allowance for credit losses and could require additional provisionsfor credit losses.

 

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DEPOSITS

 

Total deposits were $322.5 million and$298.7 million at September 30, 2004 and December 31, 2003, respectively.  Noninterest-bearing demand deposits and moneymarket deposits were $121.5 million and $72.7 million, respectively, at September30, 2004 compared to $120.0 million and $55.4 million, respectively, atDecember 31, 2003. Interest-bearing demand deposits, which are largely limitedto individuals, increased to $30.8 million at September 30, 2004 from $29.3million at December 31, 2003.  Theincrease in these accounts is attributable to an emphasis on growing businessbanking through the hiring of commercial lending officers, which generatestransaction deposit accounts.  Timecertificates of deposit (“TCDs”) increased to $62.8 million at September 30,2004 from $55.0 million at December 31, 2003 due to an increase in brokereddeposit for funding purposes. There were $7.4 million in brokered TCDs atSeptember 30, 2004 and $5.0 million brokered TCDs at December 31, 2003.

 

During the third quarter of 2004, theCompany supplemented its liquidity with brokered time certificates of depositranging in term from three months to one year. Additionally, although management has priced its retail certificates ofdeposit to encourage runoff during the past several years, in the rising rateenvironment experienced during the third quarter of 2004, it has elected togenerally maintain stable rates on its immediately repriceable base of deposits— interest-bearing demand deposits, and savings and money market deposits — andprice new time certificates of deposit to generate growth.

 

 

FEDERAL FUNDS PURCHASEDAND SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE

 

There were no federal funds purchased andsecurities sold under agreements to repurchase at September 30, 2004 comparedto $399,000 at December 31, 2003.

 

 

OTHER BORROWINGS

 

Other borrowings, consisting of advances from the Federal Home LoanBank were $31.9 million at September 30, 2004 compared to $7.5 million atDecember 31, 2003.   As part of itscurrent funding strategy the Company utilized a greater amount of overnightborrowing from the FHLB to fund its securities available-for-sale and loansreceivable.

 

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JUNIOR SUBORDINATEDDEFERRABLE INTEREST DEBENTURES

 

Junior Subordinated Debentures were $15.5 million at September 30, 2004and December 31, 2003. See Note 9 of Notes to Consolidated FinancialStatements.

 

SHAREHOLDERS’ EQUITY

 

Shareholders’ equity increased from $31.7million at December 31, 2003 to $33.9 million at September 30, 2004 due to theretained earnings for the nine months ended September 30, 2004 and the increasein market value of interest rate swaps.

 

 

***CAPITAL ADEQUACY REQUIREMENTS***

 

At September 30, 2004 the Company and theBanks were in compliance with all applicable regulatory capital requirementsand the Banks were “well capitalized” under the Prompt Corrective Action rulesof the OCC.  The following table setsforth the regulatory capital standards for well-capitalized institutions, andthe capital ratios for the Company and the Banks as of September 30, 2004 andDecember 31, 2003.

 

28

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**Regulatory Capital Information**

**of the National MercantileBancorp and Banks**

 
| ** **                       | ** ** | **Minimum**

**For Capital**

**Adequacy**

**Purposes** | ** ** | **Well**

**Capitalized**

**Standards** | ** ** | **September 30,**

**2004** | ** ** | **December 31,**

**2003** | ** ** |
|----------------------------------|------------|----------------------------------------------------------|------------|------------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| **National Mercantile Bancorp:** |       |                                                     |       |                                     |       |                        |       |                       |       |
| Tier 1 leverage                  |       | 4.00                                                     | %          | N/A                                      |       | 9.33                        | %          | 8.69                       | %          |
| Tier 1 risk-based capital        |       | 4.00                                                     | %          | N/A                                      |       | 10.73                       | %          | 11.02                      | %          |
| Total risk-based capital         |       | 8.00                                                     | %          | N/A                                      |       | 12.97                       | %          | 13.84                      | %          |
|                             |       |                                                     |       |                                     |       |                        |       |                       |       |
| **Mercantile National Bank:**    |       |                                                     |       |                                     |       |                        |       |                       |       |
| Tier 1 leverage                  |       | 4.00                                                     | %          | 5.00                                     | %          | 8.37                        | %          | 8.13                       | %          |
| Tier 1 risk-based capital        |       | 4.00                                                     | %          | 6.00                                     | %          | 10.92                       | %          | 10.88                      | %          |
| Total risk-based capital         |       | 8.00                                                     | %          | 10.00                                    | %          | 12.17                       | %          | 12.13                      | %          |
|                             |       |                                                     |       |                                     |       |                        |       |                       |       |
| **South Bay Bank, NA:**          |       |                                                     |       |                                     |       |                        |       |                       |       |
| Tier 1 leverage                  |       | 4.00                                                     | %          | 5.00                                     | %          | 9.11                        | %          | 9.44                       | %          |
| Tier 1 risk-based capital        |       | 4.00                                                     | %          | 6.00                                     | %          | 9.68                        | %          | 11.18                      | %          |
| Total risk-based capital         |       | 8.00                                                     | %          | 10.00                                    | %          | 10.70                       | %          | 12.37                      | %          |

 

 

***LIQUIDITY***

 

The Company manages its liquidity througha combination of core deposits, federal funds purchased, repurchase agreements,collateralized borrowing lines, and a portfolio of securities available forsale.  Liquidity is also provided bymaturing investment securities and loans.

 

The Company’s cash anddue from banks was $25.9 million on September 30, 2004 compared to $24.6million on December 31, 2003.  Due frombanks-interest-bearing was $2.7 million and $4.7 million at September 30, 2004and December 31, 2003, respectively. Federal funds sold were $4.0 million and $10.0 million for September 30,2004 and December 31, 2003, respectively. Mercantile had $5.0 million and South Bay had $12.0 million in Federalfunds lines with correspondent banks as of September 30, 2004.

 

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 ofsecurities and 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 Junior Subordinated Debentures. The semiannual interest payments on the Junior Subordinated Debentures,under the terms of the indenture, are deferrable at National Mercantile’soption, for a period up to ten consecutive semiannual payments, but in anyevent not beyond June 25, 2031.  TheNational Mercantile has not deferred any interest payments.

 

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National Mercantile’scash and due from banks was $0.6 million on September 30, 2004 compared to $1.2million at December 31, 2003.

 

Dividends and capitaldistributions from the Banks constitute the principal ongoing source of cash toNational Mercantile.  The Banks are subjectto various statutory and regulatory restrictions on their ability to paydividends and capital distributions to National Mercantile.

 

OCC approval is requiredfor a national bank to pay a dividend if the total of all dividends declared inany calendar year exceeds the total of the bank’s net profits (as defined) forthat year combined with its retained net profits for the preceding two calendaryears, less any required transfer to surplus or a fund for the retirement ofany preferred stock.  A national bank maynot pay any dividend that exceeds its retained net earnings, as defined by theOCC.  The OCC and the Federal Reservehave also issued banking circulars emphasizing that the level of cash dividendsshould bear a direct correlation to the level of a national bank’s current andexpected earnings stream, the bank’s need to maintain an adequate capital baseand other factors.

 

National banks that arenot in compliance with regulatory capital requirements generally are notpermitted to pay dividends.  The OCC alsocan prohibit a national bank from engaging in an unsafe or unsound practice inits business.  Depending on the bank’sfinancial condition, payment of dividends could be deemed to constitute anunsafe or unsound practice.  Except undercertain circumstances, and with prior regulatory approval, a bank may not pay adividend if, after so doing, it would be undercapitalized.  A bank’s ability to pay dividends in thefuture is, and could be, further influenced by regulatory policies oragreements and by capital guidelines.

 

Mercantile has asubstantial accumulated deficit and does not anticipate having positiveretained earnings for the foreseeable future. South Bay has an accumulated surplus of $1,017,000 as of September 30,2004.  Mercantile and South Bay may fromtime to time be permitted to make capital distributions to National Mercantilewith the consent of the OCC.  It is notanticipated that such consent could be obtained unless the distributing bankwere to remain “well capitalized” following such distribution.

 

 

 

***ASSET LIABILITY MANAGEMENT***

 

 

The following table shows that theCompany’s cumulative one-year interest rate sensitivity gap indicated an assetsensitive position of $55.1 million at September 30, 2004, a $30.7 milliondecrease from an asset sensitive position of $85.9 

 

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million at December 31,2003.  This change resulted primarilyfrom an increase in demand, money market and savings deposits repricing in lessthan three months, partially offset by an increase in adjustable loansreceivable and federal funds sold.

 

The Company’s asset sensitive positionduring a period of slowly declining interest rates is not expected to have asignificant negative impact on net interest income since rates paid on theCompany’s large base of interest-bearing demand, savings and money marketdeposits historically have not changed proportionately with changes in interestrates.  However, since the Company is inan asset sensitive position, in a period of rapidly declining rates, such asthe environment that was experienced during 2001 and 2002, the rapid declinewill have a negative effect on the Company’s net interest income as changes inthe rates of interest-bearing deposits historically have not changed in similarmagnitude to changes in market interest rates. Additionally, in relatively low and declining interest rateenvironments, the interest rates paid on funding liabilities may begin to reachfloors preventing further downward adjustments while rates on earning assetscontinue to adjust downward.

 

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**Rate-SensitiveAssets and Liabilities**

 
| ** **                                                               | ** ** | **September 30, 2004**       | ** ** |
|--------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                               | ** ** | **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  |       | $                            | 4,000      |   | $ | — |   | $ | — |   | $ | — |   | $ | 4,000 |   |
| Securities at amortized cost                                             |       | 7,667                        |       | 510 |   | 25,538 |   | 11,082 |   | 44,797 |   |
| Due from banks - interest bearing                                        |       | —                       |       | 2,728 |   | — |   | — |   | 2,728 |   |
| FRB and other stock, at cost                                             |       | —                       |       | — |   | — |   | 2,956 |   | 2,956 |   |
| Loans receivable (1)                                                     |       | 250,291                      |       | 15,897 |   | 33,204 |   | 4,182 |   | 303,574 |   |
| Total rate-sensitive assets                                              |       | 261,958                      |       | 19,135 |   | 58,742 |   | 18,220 |   | 358,055 |   |
|                                                                     |       |                         |       |   |   |   |   |   |   |   |   |
| Rate-Sensitive Liabilities: (2)                                          |       |                         |       |   |   |   |   |   |   |   |   |
| Interest bearing deposits:                                               |       |                         |       |   |   |   |   |   |   |   |   |
| Demand, money market and savings                                         |       | 138,278                      |       | — |   | — |   | — |   | 138,278 |   |
| Time certificates of deposit                                             |       | 23,580                       |       | 32,205 |   | 6,791 |   | 192 |   | 62,768 |   |
| Other borrowings                                                         |       | 25,000                       |       | 6,900 |   |   |   | — |   | 31,900 |   |
| Total rate-sensitive liabilities                                         |       | 186,858                      |       | 39,105 |   | 6,791 |   | 192 |   | 232,946 |   |
| Interest rate-sensitivity gap                                            |       | 75,100                       |       | (19,970 | ) | 51,951 |   | 18,028 |   | 125,109 |   |
| Cumulative interest rate-sensitivity gap                                 |       | $                            | 75,100     |   | $ | 55,130 |   | $ | 107,081 |   | $ | 125,109 |   |   |   |
| Cumulative ratio of rate sensitive assets to rate-sensitive  liabilities |       | 140                          | %          | 124 | % | 146 | % | 154 | % |   |   |
|                                                                          |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)     Loans receivable excludes nonaccrual loans.

(2)     Deposits which are subject to immediatewithdrawal are presented as repricing within three months or less.

The distribution of other time deposits isbased on scheduled maturities.

 

 

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*** ***

**Rate-Sensitive Assets and Liabilities**

 
| ** **                                                               | ** ** | **December 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  |       | $                            | 10,000     |   | $ | — |   | $ | — |   | $ | — |   | $ | 10,000 |   |
| Securities available-for-sale, at amortized cost                         |       | 10,507                       |       | 4,186 |   | 4,875 |   | 11,309 |   | 30,877 |   |
| Securities held-to-maturity                                              |       | —                       |       | — |   | — |   | 4,597 |   | 4,597 |   |
| Due from banks - interest bearing                                        |       | —                       |       | 4,728 |   | — |   | — |   | 4,728 |   |
| FRB and other stock, at cost                                             |       | —                       |       | — |   | — |   | 1,872 |   | 1,872 |   |
| Loans receivable (1)                                                     |       | 221,578                      |       | 6,647 |   | 27,973 |   | 4,341 |   | 260,539 |   |
| Total rate-sensitive assets                                              |       | 242,085                      |       | 15,561 |   | 32,848 |   | 22,119 |   | 312,613 |   |
|                                                                     |       |                         |       |   |   |   |   |   |   |   |   |
| Rate-Sensitive Liabilities: (2)                                          |       |                         |       |   |   |   |   |   |   |   |   |
| Interest bearing deposits:                                               |       |                         |       |   |   |   |   |   |   |   |   |
| Demand, money market and savings                                         |       | 123,696                      |       | — |   | — |   | — |   | 123,696 |   |
| Time certificates of deposit                                             |       | 28,427                       |       | 19,263 |   | 7,333 |   | — |   | 55,023 |   |
| Other borrowings                                                         |       | —                       |       | 399 |   | — |   | — |   | 399 |   |
| Total rate-sensitive liabilities                                         |       | 152,123                      |       | 19,662 |   | 7,333 |   | — |   | 179,118 |   |
| Interest rate-sensitivity gap                                            |       | 89,962                       |       | (4,101 | ) | 25,515 |   | 22,119 |   | 133,495 |   |
| Cumulative interest rate-sensitivity gap                                 |       | $                            | 89,962     |   | $ | 85,861 |   | $ | 111,376 |   | $ | 133,495 |   |   |   |
| Cumulative ratio of rate sensitive assets to rate-sensitive  liabilities |       | 159                          | %          | 150 | % | 162 | % | 175 | % |   |   |
|                                                                          |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)     Loans receivable excludes nonaccrual loans.

(2)     Deposits which are subject to immediatewithdrawal are presented as repricing within three months or less.

The distribution of other time deposits isbased on scheduled maturities.

 

33

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# ** **

# **FACTORSWHICH MAY AFFECT FUTURE OPERATING RESULTS**

 

Ourresults of operations and financial condition are affected by many factors,including the following.

 

**We face risk from changes ininterest rates.**

 

Thesuccess of our business depends, to a large extent, on our net interestincome.  Changes in market interest ratescan affect our net interest income by affecting the spread between ourinterest-earning assets and interest-bearing liabilities.  This may be due to the different maturitiesof our interest-earning assets and interest-bearing liabilities, as well as anincrease in the general level of interest rates.  Changes in market interest rates also affect,among other things:

 

**•**                  Our abilityto originate loans;

•                  The abilityof our borrowers to make payments on their loans;

•                  The value ofour interest-earning assets and our ability to realize gains from the sale ofthese assets;

•                  The averagelife of our interest-earning assets;

•                  Our abilityto generate deposits instead of other available funding alternatives; and

•                  Our abilityto access the wholesale funding market.

 

Interestrates are highly sensitive to many factors, including governmental monetarypolicies, domestic and international economic and political conditions andother factors beyond our control.

** **

**We face risk from possibledeclines in the quality of our assets.**

 

Ourfinancial condition 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.  If thelevel 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.**

 

Weestablish allowances for credit losses against each segment of our loanportfolio.  At September 30, 2004, our allowancefor credit losses equaled 1.27% of loans receivable and 1584.40% ofnonperforming loans.  Although webelieved that we had established adequate allowances for credit losses as ofSeptember 30, 2004, the credit quality of our assets is affected by manyfactors beyond our control, including local and national economic conditions,and the possible existence of

 

34

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factswhich are not known to us which adversely affect the likelihood of repayment ofvarious loans in our loan portfolio and realization of the collateral upon adefault.  Accordingly, we can give noassurance that we will not sustain loan losses materially in excess of theallowance for credit losses.  Inaddition, the Office of the Comptroller of the Currency, as an integral part ofits examination process, periodically reviews our allowance for credit lossesand could require additional provisions for credit losses.  Material future additions to the allowancefor credit losses may also be necessary due to increases in the size andchanges in the composition of our loan portfolio.  Increases in our provisions for credit losseswould adversely affect our results of operations.

 

**Economicconditions may worsen.**

 

Ourbusiness is strongly influenced by economic conditions in our market area(principally, the greater Los Angeles metropolitan area) as well as regionaland national economic conditions and in our niche markets, including theentertainment industry in Southern California. During the past several years economic conditions in these areas havebeen generally unfavorable.  Should theeconomic condition in these areas continue to be unfavorable, the financialcondition of our borrowers could weaken, which could lead to higher levels ofloan defaults or 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.

** **

**Because a significant amount ofthe loans we make are to borrowers in California, our operations could sufferas a result of local recession or natural disasters in California.**

 

AtSeptember 30, 2004, a large majority of our loans outstanding werecollateralized by real properties located in California.  Because of this concentration in California,our financial position and results of operations have been and are expected tocontinue to be influenced by general trends in the California economy and itsreal estate market.  Real estate marketdeclines may adversely affect the values of the properties collateralizingloans.  If the principal balances of ourloans, together with any primary financing on the mortgaged properties, equalor exceed the value of the mortgaged properties, we could incur higher losseson sales of properties collateralizing foreclosed loans.  In addition, California historically has beenvulnerable to certain natural disaster risks, such as earthquakes anderosion-caused mudslides, which are not typically covered by the standardhazard insurance policies maintained by borrowers.  Uninsured disasters may adversely impact ourability to recover losses on properties affected by such disasters andadversely impact our results of operations.

** **

**Our business is very competitive.**

 

Thereis intense competition in Southern California and elsewhere in the UnitedStates for banking customers.  Weexperience competition for deposits from many sources, including credit unions,insurance companies and money market and

 

35

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othermutual funds, as well as other commercial banks and savings institutions.  We compete for loans and deposits primarilywith other commercial banks, mortgage companies, commercial finance companiesand savings institutions.  In recentyears out-of-state financial institutions have entered the California market,which has also increased competition. Many of our competitors have greater financial strength, marketingcapability and name recognition than we do, and operate on a statewide ornationwide basis.  In addition, recentdevelopments in technology and mass marketing have permitted larger companiesto market loans more aggressively to our small business customers.  Such advantages may give our competitorsopportunities to realize greater efficiencies and economies of scale than wecan.  We can provide no assurance that wewill be able to compete effectively against our competition.

 

**Our business is heavily regulated.**

 

BothNational Mercantile as a bank holding company, and Mercantile and South Bay, asnational banks, are subject to significant governmental supervision andregulation, 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.

** **

**We test goodwill annually and must record any impairment as acharge to earnings**.

 

Statementof Financial 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.

 

Werecorded goodwill of $3.2 million in connection with the South Bay acquisitionin December 2001.  During the fourthquarter of 2003, 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 deferred tax asset will berealized and must establish a valuation allowance if necessary to reduce it toits realizable value.**

 

36

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         On a periodic basis, at least annually,we perform an analysis to determine if it is more likely than not that some orall 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:

 

•                  Futureearnings are assured;

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

 

Avaluation allowance may be established to reduce the deferred tax asset to itsrealizable value.  The determination ofwhether a valuation allowance is necessary involves considering the positiveand negative factors related to whether the deferred tax asset is more likelythan not to be realized.  Any adjustmentrequired to the valuation allowance is coupled with a related entry to incometax expense.  A charge to earnings willbe made in the event that we determine that a valuation allowance to thedeferred tax asset is necessary. No such valuation allowance exists atSeptember 30, 2004.

 

CAUTIONARY NOTE REGARDINGFORWARD-LOOKING STATEMENTS

 

Statements in theQuarterly Report on Form 10-QSB under the caption “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” and elsewhere inthis report are forward-looking and are based upon information currentlyavailable to the Company.  The Company,through its officers, directors or employees, may also from time to time makeoral forward-looking statements.   Anysuch statement is qualified by reference to these cautionary statements.   In connection with the “safe harbor”provisions of the Private Securities Litigation Reform Act of 1995, the Companyis hereby identifying important factors that could cause actual results todiffer materially from those contained in any forward-looking statement made byor on behalf of the Company.

 

Undue reliance should notbe placed on the Company’s forward-looking statements because the matters theydescribe are subject to known and unknown risks, uncertainties and otherunpredictable factors, many of which are beyond the Company’s control.  The Company’s forward-looking statementsspeak only as of the date on which this report was filed with United StatedSecurities and Exchange Commission.  Overtime, actual results, performance or achievements will likely differ from theanticipated results, performance or achievements that are expressed or impliedby the Company’s forward-looking statements, and such difference might besignificant and materially adverse to the Company’s stockholders.

 

All subsequentwritten or oral forward-looking statements attributable to the Company orpersons acting on the Company’s behalf are expressly qualified by the factorsdescribed above.   The Company assumes noobligation, and disclaims any obligation, to update information contained inthe Quarterly Report on Form 10-QSB, including forward-looking

 

37

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statements, as a resultof facts, events or circumstances after the date of this report, except asrequired by law in the normal course of its public disclosure practices.

 

 

***ITEM3. CONTROLS AND PROCEDURES***

 

TheCompany’s management, with the participation of the Chief Executive Officer andChief Financial Officer, has conducted an evaluation of the effectiveness ofthe Company’s disclosure controls and procedures pursuant to Rule 13a-14 underthe Securities Exchange Act of 1934, as amended, as of the end of the periodcovered by this report. Based on that evaluation, the Chief Executive Officerand the Chief Financial Officer believe that the Company’s disclosure controlsand procedures reasonably ensure that information required to be disclosedby the Company in this quarterly report has been made known to them in a timelymanner.

 

Therewas no change in the Company’s internal control over financial reporting duringthe Company’s most recently completed fiscal quarter that has materiallyaffected, or is reasonably likely to materially affect, the Company’s internalcontrol over financial reporting.

 

 

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**PARTII—OTHER INFORMATION**

 

***Item1.       LEGAL PROCEEDINGS***

 

None.

 

***Item 2.       CHANGESIN SECURITIES***

 

None.

 

***Item3.       DEFAULTS UPON SENIOR SECURITIES***

 

None.

 

***Item4.       SUBMISSION OF MATTERS TO A VOTEOF SECURITY HOLDERS***

 

None.

 

***Item 5.       OTHERINFORMATION***

 

None.

 

***Item 6.       EXHIBITS***

 

 

*      *31.1Certification of Scott A. Montgomery on disclosure controls.

       31.2Certification of David R. Brown on disclosure controls.

       32.1 Certification of Scott A. Montgomerypursuant to section 906 of the Sarbanes-Oxley Act of 2002

       32.2Certification of David R. Brown pursuant to section 906 of the Sarbanes-Oxley Actof 2002

 

 

**SIGNATURES**

 

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

 

 

 

 
|   |               |   | **NATIONAL MERCANTILE BANCORP**                       |
|--------|--------------------|--------|-------------------------------------------------------|
|   |               |   | (Registrant)                                          |
|   |               |   |                                                  |
| DATE:  | November 15 , 2004 |   | /s/  SCOTT  A. MONTGOMERY                        |
|   |               |   | **Scott A. Montgomery**                               |
|   |               |   | Chief  Executive Officer                              |
|   |               |   |                                                  |
| DATE:  | November 15 , 2004 |   | /s/  DAVID  R. BROWN                             |
|   |               |   | **David R. Brown**                                    |
|   |               |   | Principal  Financial and Principal Accounting Officer |

 

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