**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**Form 10-QSB**

 

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

**for the quarterly period ended March 31, 2006**

 

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

 
| **Commission File Number 0-15982** | ** ** | ** ** |
|------------------------------------|------------|------------|

 

**NATIONAL MERCANTILE BANCORP**

(Exact name of small business issuer in its charter)

 

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

 

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

 

Checkwhether the issuer:  (1) filed allreports required to be filed by Section 13 or 15(d) of the ExchangeAct of 1934 during the past 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.      ýYes           o   No

 

Indicated by checkmarkwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).  o Yes   ý No

 

The number of shares ofCommon Stock, no par value, of the issuer outstanding as of  May 15, 2006 was 5,541,280.

 

TransitionalSmall Business Disclosure Format (Check one):      o Yes              ý    No

 

 

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PART I– FINANCIAL INFORMATION

 

*Item 1. Financial Statements*

 

Presented are theunaudited consolidated financial statements of National Mercantile Bancorp (“NationalMercantile” on a parent-only basis, and the “Company” on a consolidated basis)and its wholly-owned subsidiaries, Mercantile National Bank (“Mercantile”) andSouth Bay Bank, N.A. (“South Bay”), (collectively, the “Banks”). 

 

2

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**NATIONAL MERCANTILEBANCORP AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

**(Unaudited)**

 
| ** **                                                                                                                                                                   | ** ** | **March 31,**                   | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                   | ** ** | **2006**                             | ** ** | **2005**              | ** ** |
| ** **                                                                                                                                                                   | ** ** | **(Dollars in thousands)** | ** ** |
| ASSETS                                                                                                                                                                       |       |                                 |       |                  |       |
| Cash and due from banks-demand                                                                                                                                               |       | $                                    | 15,211     |                  | $          | 13,507 |   |
| Due from banks-interest bearing                                                                                                                                              |       | 2,000                                |       | 2,000                 |       |
| Federal funds sold                                                                                                                                                           |       | 2,790                                |       | 685                   |       |
| Cash and cash  equivalents                                                                                                                                                   |       | 20,001                               |       | 16,192                |       |
| Securities available-for-sale, at fair value;  aggregate amortized cost of $87,278 and $72,428 at March 31, 2006 and December 31,  2005, respectively              |       | 85,825                               |       | 71,758                |       |
| Securities held-to-maturity, at amortized cost;  aggregate fair value of $2,370 and $2,572 at March 31, 2006 and December 31,  2005, respectively                  |       | 2,438                                |       | 2,612                 |       |
| Federal Reserve Bank and other stock                                                                                                                                         |       | 3,940                                |       | 3,809                 |       |
| Loans receivable                                                                                                                                                             |       | 353,500                              |       | 338,558               |       |
| Allowance for  credit losses                                                                                                                                                 |       | (4,562                               | )          | (4,468                | )          |
| Net loans  receivable                                                                                                                                                        |       | 348,938                              |       | 334,090               |       |
|                                                                                                                                                                         |       |                                 |       |                  |       |
| Premises and equipment, net                                                                                                                                                  |       | 5,877                                |       | 5,861                 |       |
| Other real estate owned                                                                                                                                                      |       | —                               |       | 1,056                 |       |
| Deferred tax asset, net                                                                                                                                                      |       | 3,864                                |       | 4,203                 |       |
| Goodwill                                                                                                                                                                     |       | 3,225                                |       | 3,225                 |       |
| Intangible assets, net                                                                                                                                                       |       | 1,351                                |       | 1,407                 |       |
| Accrued interest receivable and other assets                                                                                                                                 |       | 4,471                                |       | 4,583                 |       |
| Total assets                                                                                                                                                                 |       | $                                    | 479,930    |                  | $          | 448,796 |   |
|                                                                                                                                                                         |       |                                 |       |                  |       |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                                                                    |       |                                 |       |                  |       |
| Deposits:                                                                                                                                                                    |       |                                 |       |                  |       |
| Noninterest-bearing demand                                                                                                                                                   |       | $                                    | 122,638    |                  | $          | 115,924 |   |
| Interest-bearing demand                                                                                                                                                      |       | 31,716                               |       | 36,018                |       |
| Money market                                                                                                                                                                 |       | 91,885                               |       | 76,334                |       |
| Savings                                                                                                                                                                      |       | 26,336                               |       | 28,208                |       |
| Time certificates of deposit:                                                                                                                                                |       |                                 |       |                  |       |
| $100,000 or more                                                                                                                                                             |       | 114,296                              |       | 87,468                |       |
| Under $100,000                                                                                                                                                               |       | 18,481                               |       | 19,256                |       |
| Total deposits                                                                                                                                                               |       | 405,352                              |       | 363,208               |       |
|                                                                                                                                                                         |       |                                 |       |                  |       |
| Securities sold under agreement to repurchase                                                                                                                                |       | 15,000                               |       | —                |       |
| Other borrowings                                                                                                                                                             |       | 1,400                                |       | 28,337                |       |
| Junior subordinated deferrable interest debentures                                                                                                                           |       | 15,464                               |       | 15,464                |       |
| Accrued interest payable and other liabilities                                                                                                                               |       | 3,414                                |       | 3,288                 |       |
| Total  liabilities                                                                                                                                                           |       | 440,630                              |       | 410,297               |       |
|                                                                                                                                                                         |       |                                 |       |                  |       |
| Shareholders’ equity:                                                                                                                                                   |       |                                 |       |                  |       |
| Preferred stock, no par value-authorized 1,000,000  shares:                                                                                                                  |       |                                 |       |                  |       |
| Series B  non-cumulative convertible perpetual preferred stock; authorized 1,000  shares; outstanding 1,000 shares at March 31, 2006 and December 31,  2005   |       | 1,000                                |       | 1,000                 |       |
| Common stock, no par value-authorized 10,000,000  shares: outstanding 5,541,280 shares and 5,503,780 shares at March 31,  2006 and December 31, 2005, respectively |       | 45,976                               |       | 45,697                |       |
| Accumulated deficit                                                                                                                                                          |       | (5,726                               | )          | (7,044                | )          |
| Accumulated other comprehensive loss                                                                                                                                         |       | (1,950                               | )          | (1,154                | )          |
| Total  shareholders’ equity                                                                                                                                             |       | 39,300                               |       | 38,499                |       |
| Total  liabilities and shareholders’ equity                                                                                                                             |       | $                                    | 479,930    |                  | $          | 448,796 |   |

 

See accompanying notes toconsolidated financial statements.

 

3

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**NATIONAL MERCANTILEBANCORP AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

(Unaudited)

 
| ** **                                                              | ** ** | **For the Three Months  Ended**           | ** ** |
|-------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                              | ** ** | **March 31,**                        | ** ** |
| ** **                                                              | ** ** | **2006**                                  | ** ** | **2005** | ** ** |
| ** **                                                              | ** ** | **(Dollars in thousands,**      | ** ** |
| ** **                                                              | ** ** | **except per share data)** | ** ** |
| Interest income:                                                        |       |                                      |       |   |   |
| Loans, including fees                                                   |       | $                                         | 7,040      |   | $ | 5,443 |   |
| Securities                                                              |       | 985                                       |       | 368 |   |
| Due from banks                                                          |       | 21                                        |       | 16 |   |
| Federal funds sold and securities purchased under  agreements to resell |       | 5                                         |       | 10 |   |
| Total interest income                                                   |       | 8,051                                     |       | 5,837 |   |
| Interest expense:                                                       |       |                                      |       |   |   |
| Interest-bearing demand                                                 |       | 42                                        |       | 32 |   |
| Money market and savings                                                |       | 584                                       |       | 220 |   |
| Time certificates of deposit:                                           |       |                                      |       |   |   |
| $100,000 or more                                                        |       | 768                                       |       | 208 |   |
| Under $100,000                                                          |       | 176                                       |       | 142 |   |
| Total interest expense on deposits                                      |       | 1,570                                     |       | 602 |   |
| Securities sold under agreements to repurchase                          |       | 145                                       |       | — |   |
| Other borrowings                                                        |       | 224                                       |       | 280 |   |
| Junior subordinated deferrable interest debentures                      |       | 353                                       |       | 94 |   |
| Total interest expense                                                  |       | 2,292                                     |       | 976 |   |
| Net interest income before provision for credit  losses                 |       | 5,759                                     |       | 4,861 |   |
| Provision for credit losses                                             |       | 32                                        |       | 89 |   |
| Net interest income after provision for credit  losses                  |       | 5,727                                     |       | 4,772 |   |
| Other operating income:                                                 |       |                                      |       |   |   |
| International services                                                  |       | 33                                        |       | 10 |   |
| Investment division                                                     |       | 9                                         |       | 15 |   |
| Deposit-related and other customer services                             |       | 232                                       |       | 297 |   |
| Gain on sale of other real estate owned                                 |       | 48                                        |       | — |   |
| Total other operating income                                            |       | 322                                       |       | 322 |   |
| Other operating expenses:                                               |       |                                      |       |   |   |
| Salaries and related benefits                                           |       | 2,089                                     |       | 1,838 |   |
| Net occupancy                                                           |       | 261                                       |       | 246 |   |
| Furniture and equipment                                                 |       | 133                                       |       | 127 |   |
| Printing and communications                                             |       | 166                                       |       | 145 |   |
| Insurance and regulatory assessments                                    |       | 99                                        |       | 108 |   |
| Client services                                                         |       | 142                                       |       | 172 |   |
| Computer data processing                                                |       | 217                                       |       | 232 |   |
| Legal services                                                          |       | 74                                        |       | 148 |   |
| Other professional services                                             |       | 304                                       |       | 254 |   |
| Amortization of core deposit intangible                                 |       | 56                                        |       | 56 |   |
| Promotion and other expenses                                            |       | 191                                       |       | 160 |   |
| Total other operating expenses                                          |       | 3,732                                     |       | 3,486 |   |
| Income before income tax provision                                      |       | 2,317                                     |       | 1,608 |   |
| Income tax provision                                                    |       | 999                                       |       | 667 |   |
| Net income                                                              |       | $                                         | 1,318      |   | $ | 941 |   |
| Earnings per share:                                                     |       |                                      |       |   |   |
| Basic                                                                   |       | $                                         | 0.24       |   | $ | 0.25 |   |
| Diluted                                                                 |       | $                                         | 0.22       |   | $ | 0.16 |   |

 

See accompanying notes to consolidated financial statements.

 

4

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**NATIONAL MERCANTILEBANCORP AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

(Unaudited)

 
| ** **                                                                                  | ** ** | **For the Three Months Ended March 31,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                                                                  | ** ** | **2006**                                                               | ** ** | **2005** | ** ** |
| ** **                                                                                  | ** ** | **(Dollars in thousands)**                                   | ** ** |
| Cash flows from operating activities:                                                       |       |                                                                   |       |   |   |
| Net income                                                                                  |       | $                                                                      | 1,318      |   | $ | 941 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities:          |       |                                                                   |       |   |   |
| Depreciation and amortization                                                               |       | 116                                                                    |       | 103 |   |
| Provision for credit losses                                                                 |       | 32                                                                     |       | 89 |   |
| Gain on sale of other real estate owned                                                     |       | (48                                                                    | )          | — |   |
| Net amortization of discount on securities  available-for-sale                              |       | (21                                                                    | )          | 19 |   |
| Net amortization of premium on securities  held-to-maturity                                 |       | 5                                                                      |       | 8 |   |
| Net amortization of core deposit intangible                                                 |       | 56                                                                     |       | 56 |   |
| Net amortization of premium on loans purchased                                              |       | 32                                                                     |       | 41 |   |
| Utilization of deferred tax assets                                                          |       | 759                                                                    |       |   |   |
| Decrease (increase) in accrued interest receivable  and other assets                        |       | (287                                                                   | )          | 467 |   |
| Increase (decrease) in accrued interest payable and  other liabilities                      |       | 187                                                                    |       | (668 | ) |
| Net cash provided by operating activities                                                   |       | 2,149                                                                  |       | 1,056 |   |
| Cash flows from investing activities:                                                       |       |                                                                   |       |   |   |
| Purchase of securities available-for-sale                                                   |       | (24,513                                                                | )          | (536 | ) |
| Proceeds from repayments and maturities of  securities available-for-sale                   |       | 10,114                                                                 |       | 1,336 |   |
| Proceeds from repayments and maturities of  securities held-to-maturity                     |       | 169                                                                    |       | 215 |   |
| Loan originations and principal collections, net                                            |       | (14,973                                                                | )          | 4,219 |   |
| Proceeds from sale of other real estate owned                                               |       | 1,104                                                                  |       | — |   |
| Purchase of Federal Reserve stock and other stocks                                          |       | (595                                                                   | )          | (195 | ) |
| Purchases of premises and equipment                                                         |       | (132                                                                   | )          | (140 | ) |
|                                                                                        |       |                                                                   |       |   |   |
| Net cash provided by (used in) investing activities                                         |       | (28,826                                                                | )          | 4,899 |   |
| Cash flows from financing activities:                                                       |       |                                                                   |       |   |   |
| Net increase in demand deposits, money market and  savings accounts                         |       | 16,091                                                                 |       | 6,777 |   |
| Net increase in time certificates of deposit                                                |       | 26,053                                                                 |       | 5,456 |   |
| Net increase in securities sold under agreements to  repurchase and federal funds purchased |       | 15,000                                                                 |       | — |   |
| Net decrease in other borrowings                                                            |       | (26,937                                                                | )          | (16,000 | ) |
| Net proceeds from exercise of stock options                                                 |       | 279                                                                    |       | 187 |   |
| Net cash provided by (used in) financing activities                                         |       | 30,486                                                                 |       | (3,580 | ) |
| Net increase in cash and cash equivalents                                                   |       | 3,809                                                                  |       | 2,375 |   |
| Cash and cash equivalents, January 1                                                   |       | 16,192                                                                 |       | 16,915 |   |
| Cash and cash equivalents, March 31                                                    |       | $                                                                      | 20,001     |   | $ | 19,290 |   |
|                                                                                        |       |                                                                   |       |   |   |
| Supplemental disclosures of cash flow information:                                          |       |                                                                   |       |   |   |
| Cash paid for interest                                                                      |       | $                                                                      | 2,112      |   | $ | 1,205 |   |
| Cash paid for income taxes                                                                  |       | 325                                                                    |       | 290 |   |
| Unrealized loss on securities available-for-sale,  net of tax effect                        |       | 353                                                                    |       | 173 |   |
| Unrealized loss on swap, net of tax effect                                                  |       | $                                                                      | 1,076      |   | $ | 636 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

5

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**NATIONAL MERCANTILE BANCORP ANDSUBSIDIARIES**

###### **NOTES TO THE CONSOLIDATEDFINANCIAL STATEMENTS**

**(Unaudited)**

 

NOTE 1—BASIS OF PRESENTATION AND MANAGEMENT REPRESENTATIONS

 

The unauditedconsolidated financial statements include the accounts of National MercantileBancorp (“National Mercantile” on a parent-only basis, and the “Company” on aconsolidated basis) and its wholly-owned subsidiaries, Mercantile National Bankand South Bay Bank, N.A., (collectively, the “Banks”). The unauditedconsolidated financial statements of the Company 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 months ended March 31, 2006 are notnecessarily indicative of the results expected for any subsequent period or forthe full year ending December 31, 2006. The unaudited consolidatedfinancial statements should be read in conjunction with the auditedconsolidated financial statements included in the Company’s Annual Report on Form 10-KSBfor the year ended December 31, 2005.

 

NOTE 2—EARNINGS PER SHARE

 

Basic earnings pershare are computed using the weighted average number of common sharesoutstanding during the period. The weighted average number of common sharesoutstanding used in computing basic earnings per share and diluted earnings pershare was 5,518,583 and 6,002,461, respectively, for the three months ended March 31,2006. The weighted average number of common shares outstanding used incomputing basic earnings per share and diluted earnings per share was 3,716,154and 5,813,785, respectively, for the three months ended March 31, 2005. Thenumber of shares has been adjusted for the five-for-four stock split effectedin the form of a stock dividend paid April 14, 2006 and reflect theconversion of the Series A Preferred Stock in June 2005.

 

The followingtable is a reconciliation of income and shares used in the computation of basicand diluted earnings per share:

 

6

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| ** **                                        | ** ** | ** **          | ** ** | **Weighted** | ** ** | ** **         | ** ** |
|---------------------------------------------------|------------|---------------------|------------|--------------|------------|--------------------|------------|
| ** **                                        | ** ** | ** **          | ** ** | **Average**  | ** ** | **Per share** | ** ** |
| ** **                                        | ** ** | **Net Income** | ** ** | **Shares**   | ** ** | **amount**         | ** ** |
| ** **                                        | ** ** | **(in thousands)**  | ** ** | ** **   | ** ** | ** **         | ** ** |
| ** **                                        | ** ** | ** **          | ** ** | ** **   | ** ** | ** **         | ** ** |
| *For the three months ended March 31, 2006:* |       |                |       |         |       |               |       |
| Basic earnings per share                          |       | $                   | 1,318      |         | 5,518,383  |               | $          | 0.24 |   |
|                                              |       |                |       |         |       |               |       |
| Effect of dilutive securities:                    |       |                |       |         |       |               |       |
| Options                                           |       |                |       | 267,414      |       |               |       |
| Convertible preferred stock                       |       |                |       | 216,664      |       |               |       |
| Diluted earnings per share                        |       | $                   | 1,318      |         | 6,002,461  |               | $          | 0.22 |   |
|                                              |       |                |       |         |       |               |       |
| *For the three months ended March 31, 2005:* |       |                |       |         |       |               |       |
| Basic earnings per share                          |       | $                   | 941        |         | 3,716,154  |               | $          | 0.25 |   |
|                                              |       |                |       |         |       |               |       |
| Effect of dilutive securities:                    |       |                |       |         |       |               |       |
| Options                                           |       |                |       | 246,269      |       |               |       |
| Convertible preferred stock                       |       |                |       | 1,851,363    |       |               |       |
| Diluted earnings per share                        |       | $                   | 941        |         | 5,813,785  |               | $          | 0.16 |   |

 

NOTE 3—CASH AND CASH EQUIVALENTS

 

For purposes ofreporting cash flows, cash and cash equivalents include cash, due frombanks-interest-bearing and federal funds sold.

 

NOTE 4—ALLOWANCE FOR LOAN AND LEASE LOSSES 

 

The allowance forloan and lease losses is a valuation adjustment used to recognize impairment ofthe recorded investment in the Company’s loans receivable on its balance sheetbefore losses have been confirmed resulting in a subsequent charge-off orwrite-down.

 

Provisions for creditlosses charged (or credited) to operations reflect management’s judgment of theadequacy of the allowance for loan and lease losses and are determined throughperiodic analysis of the loan portfolio. This analysis includes a systematicand detailed review of the classification and categorization of problem loans;an assessment of the overall quality and collectibility of the portfolio; andconsideration of the loan loss experience, trends in problem loans,concentrations of credit risk, as well as current economic conditions(particularly Southern California). Management performs a periodic risk andcredit analysis, the results of which are reported to the Board of Directors.

 

7

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During the first quarter2006, the Company charged off $1,000 and had no recoveries of loans previouslycharged off. Pursuant to Management’s evaluation of the allowance for loan andlease losses at March 31, 2006, a provision for credit losses of $32,000was recorded for the first quarter 2006.

 

The followingtable sets forth information concerning the Company’s allowance for creditlosses for the periods indicated.

 
| ** **                                                                | ** ** | **Allowance for Loan  and Lease Losses** | ** ** |
|---------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                | ** ** | **(Dollars in thousands)**                         | ** ** |
| For the three months ended March 31, 2006                            |       |                                                         |       |
| Balance, beginning of period                                              |       | $                                                            | 4,468      |   |
| Total loans charged-off                                                   |       | 1                                                            |       |
| Total recoveries of loans previously charged off                          |       | —                                                       |       |
| Net charge-offs                                                           |       | 1                                                            |       |
| Provision for credit losses                                               |       | 32                                                           |       |
| Transfer to (from) reserve for contingent losses on  unfunded commitments |       | 63                                                           |       |
| Balance, end of period                                                    |       | $                                                            | 4,562      |   |
|                                                                      |       |                                                         |       |
| For the three months ended March 31, 2005                            |       |                                                         |       |
| Balance, beginning of period                                              |       | $                                                            | 3,511      |   |
| Total loans charged-off                                                   |       | 6                                                            |       |
| Total recoveries of loans previously charged off                          |       | 3                                                            |       |
| Net charge-offs                                                           |       | 3                                                            |       |
| Provision for credit losses                                               |       | 89                                                           |       |
| Transfer to allowance for contingent losses on  unfunded commitments      |       | 1                                                            |       |
| Balance, end of period                                                    |       | $                                                            | 3,598      |   |

 

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

 

8

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NOTE 5—GOODWILL AND COREDEPOSIT INTANGIBLES

 

As of March 31, 2006and December 31, 2005, the Company had goodwill of $3.2 million, and netcore deposit intangibles of $1.4 million from its acquisition of South Bay Bankin December 2001. The gross carrying amount of core deposit intangibleswas $2.3 million at March 31, 2006 and December 31, 2005, andaccumulated amortization was $949,000 and $893,000, respectively, at such dates.The core deposit intangibles are estimated to have a life of 10 years and 4months. Amortization of intangibles for 2006 and each of the next four years isestimated to be $223,000 per year. In accordance with SFAS No. 142goodwill is not amortized. The Company has no other recorded indefinite-livedintangible assets. Goodwill and other intangible assets are reviewed andassessed annually for impairment or more frequently if conditions suggestimpairment may exist.

 

NOTE 6—REPURCHASEAGREEMENTS

 

At March 31, 2006,the Company had $15.0 million of securities sold under agreement to repurchase (“RepurchaseAgreements”). At December 31, 2005, there were no Repurchase Agreements. TheRepurchase Agreements entered into during the first quarter 2006 are adjustable,indexed to LIBOR, and contain embedded interest rate floors with a 4.0% strikerate for a term of two years and were utilized to facilitate the Company’sliquidity and interest rate risk management objectives. In the event of asustained decline in interest rates, upon reaching the strike rate, the cost ofthe Repurchase Agreements will decline at double the difference between theindex rate and the strike rate, but in any event, not below zero.

 

The embedded interestrate floor has not been separated from the Repurchase Agreement and accountedfor as a derivative instrument because (i) the strike rate was below theLIBOR index at issuance of the Repurchase Agreement and it is clearly andclosely related to the economic characteristics and risks of the Repurchase Agreements,and (ii) the Repurchase Agreement is not remeasured at fair value underotherwise applicable generally accepted accounting principles with changes infair value reported in earnings.

 

NOTE 7—INCOME TAXES

 

Income taxprovisions of $999,000 and $667,000 were recorded for the three months ended March 31,2006 and 2005, respectively.

 

9

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At March 31,2006, the Company had: (i) federal net operating loss carry forwards (“NOLS”)of approximately $2.8 million, which begin to expire in the year 2009; and (ii) federalalternative minimum tax (“AMT”) credits of $819,000. The AMT credits carryforward indefinitely.

 

Managementbelieves that it is more likely than not that the deferred tax asset, a portionof which is comprised of the NOLS, will be realized. Accordingly, no valuationallowance has been established against the deferred tax asset.

 

NOTE 8—SHARE-BASEDPAYMENTS

 

At March 31, 2006,the Company had one stock incentive plan pursuant to which up to a total of 312,500shares of common stock may be issued. Under this plan, the Company may grantto directors, officers, employees and consultants stock-based incentivecompensation in a variety of forms, including without limitation nonqualifiedoptions, incentive options, sales and bonuses of common stock and stockappreciation rights, on such terms and conditions as the Board of Directors ofthe Company determines. The term of the stock option may not exceed 10years. Employee stock option grants generally vest over one year or ratableover two years. Director stock options vest in one year. All stock options havevesting conditions that include only service conditions; none of the grantscontains performance or market vesting conditions.

 

The Company issues newshares upon the exercise of stock options. All of the share-based paymentawards qualify for classification as equity. At March 31, 2006, the onlyoutstanding awards under this plan were stock options, and at that date 193,430shares were available for future awards. At March 31, 2006, there werealso outstanding options granted under two prior stock incentive plans. Theactivity of stock options for the three months ended March 31, 2006 is asshown:

 
| ** **                          | ** ** | **No. of  Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|-------------------------------------|------------|-------------------------|------------|--------------------------------------------|------------|-----------------------------------------------------|------------|-------------------------------------|------------|
| Outstanding, December 31, 2005 |       | 519,358                 |       | $                                          | 9.62       |                                                | 6.3        |                                | $          | 4,996,224 |   |
| Granted                             |       | 3,100                   |       | 18.19                                      |       | 9.8                                                 |       | 56,389                              |       |
| Exercised                           |       | (29,750                 | )          | 7.54                                       |       | 5.3                                                 |       | 224,315                             |       |
| Forefeited                          |       | (6,750                  | )          | 12.40                                      |       | 9.0                                                 |       | 83,700                              |       |
| Expired                             |       | —                  |       | —                                     |       | —                                              |       | —                              |       |
| Five-for-four stock split           |       | 121,490                 |       | n/a                                        |       | n/a                                                 |       | n/a                                 |       |
| Outstanding, March 31, 2006    |       | 607,448                 |       | $                                          | 7.81       |                                                | 6.0        |                                | 4,744,165  |   |
|                                |       |                    |       |                                       |       |                                                |       |                                |       |
| Exercisable, March 31, 2006    |       | 382,659                 |       | $                                          | 5.95       |                                                | 4.6        |                                | 2,276,821  |   |
| Unvested, March 31, 2006       |       | 224,789                 |       | $                                          | 8.68       |                                                | 8.7        |                                | 1,951,164  |   |
|                                     |            |                         |            |                                            |            |                                                     |            |                                     |            |  |  |

 

The Financial AccountingStandards Board issued Statement of Financial Accounting Standards No. 123R,“Share-Based Payment” (SFAS 123R) which eliminated the ability to account forshare-based compensation transactions, including grants of employee stockoptions, using Accounting Principles Board Opinion No. 25, “Accounting forStock Issued to Employees”

 

10

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(APB 25), and generallyrequires that such transactions be accounted for using a fair value-basedmethod with the resulting compensation cost recognized over the period that theemployee is required to provide service in order to receive their compensation.The Company adopted SFAS 123R as of January 1, 2006 utilizing the modifiedprospective application. Under this method, the provisions of SFAS 123R areapplied to new awards and to awards modified, repurchased or canceled after December 31,2005 and to awards outstanding on December 31, 2005 for which therequisite service has not yet been rendered. Prior to December 31, 2005,the Company accounted for its stock options using the intrinsic value method,as prescribed by APB 25, and accordingly, no expense for stock options wasrecorded in periods prior to December 31, 2005.

 

In the first quarter of2006, the adoption of SFAS 123R resulted in incremental share-basedcompensation expense of $85,000, net income before income tax and net income todecrease by $85,000, and basic and diluted earnings per share to decrease by$0.02 and $0.01, respectively. The income tax benefit for the three monthsended March 31, 2006 was immaterial as nearly all unvested stock optionswere qualified incentive stock options. For the three months ended March 31,2006, there was no impact to cash flow from financing activities as there wereno tax deductions that exceeded the compensation cost for share-based payments.

 

The reported net incomeand earnings per share for the three months ended March 31, 2005 arepresented below to reflect the impact had the Company been required torecognize compensation expense based on SFAS 123R:

 

| ** **                                                                                                    | ** ** | **March 31,**                   | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                                    | ** ** | **2005**                             | ** ** |
| ** **                                                                                                    | ** ** | **(Dollars in thousands)** | ** ** |
|                                                                                                          |       |                                 |       |
| Reported net income                                                                                           |       | $                                    | 941        |   |
| Deduct: Toal share-based compensation expense  determined using fair value method, net of related tax effects |       | (36                                  | )          |
|                                                                                                          |       | 905                                  |       |
|                                                                                                          |       |                                 |       |
| Basic earnings per share:                                                                                     |       |                                 |       |
| As reported                                                                                                   |       | $                                    | 0.25       |   |
| Pro forma                                                                                                     |       | $                                    | 0.24       |   |
|                                                                                                          |       |                                 |       |
| Diluted earnings per share:                                                                                   |       |                                 |       |
| As reported                                                                                                   |       | $                                    | 0.16       |   |
| Pro forma                                                                                                     |       | $                                    | 0.15       |   |

 

The estimated per shareweighted average fair value of options granted in the three months ended March 31,2006 and 2005 was $6.49 and $8.60, respectively. The total intrinsic value ofoptions exercised during the three months ended March 31, 2006 was $224,000and the total fair value of shares vested during this period was $99,000. As ofMarch 31, 2006, total unrecognized compensation cost related to stockoptions issued but unvested was $420,000 that will be recognized through 2008.

 

11

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Under the fair valuemethod, stock option compensation expense is measured on the date of grantusing an option-pricing model. Upon adoption of SFAS 123R, the fair values ofthe stock options were estimated using a lattice option pricing model. Previously,the fair values of stock options were estimated using the Black-Scholesoption-pricing model. Due to longer contractual terms of the Company’s stockoptions than traded options, suboptimal exercise patterns and risk-freeinterest rates and dividend rates that may be expected to differ over theoption term from the grant date, the lattice option pricing model betterreflects the substantive characteristics of the Company’s stock options. Theeffect of the change to the lattice option pricing model did not have amaterial impact on the current period.

 

The lattice optionpricing models require certain assumptions. For the three months ended March 31,2006, the expected volatility assumption of 32% is based upon the weeklyhistorical volatility of the Company’s stock price for the period January 1,2000 through December 31, 2005 using a blend of the unweighted standarddeviation of closing price with a weighted mean reversion formula. Therisk-free interest rate assumption ranged from 4.46% to 4.50% for the expectedterm of the share options and is based upon the U.S. Treasury implied forwardyield curve at the time of the grant. The dividend yield assumption ranged from0 to 2.5% during the expected term of the options and is based upon the Company’scapital planning model. The assumptions used with the Black-Sholes optionpricing model, for the three months ended March 31, 2005, are as follows:expected volatility 43%; expected term 10 years; risk-free interest rate 4.50%;and dividend yield 0%.

 

NOTE 9—COMPREHENSIVEINCOME (LOSS)

 

Comprehensive income(loss) is the change in equity during a period from transactions and otherevents and circumstances from nonowner sources. The accumulated balance ofother comprehensive income (loss) is required to be displayed separately fromretained earnings in the consolidated balance sheet. Total comprehensive income(loss) was as follows:

 

12

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| ** **                                                                          | ** ** | **Three Months ended March 31,** | ** ** |
|-------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                          | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| ** **                                                                          | ** ** | **(Dollars in thousands)**                 | ** ** |
|                                                                                |       |                                                 |       |   |   |
| Net income                                                                          |       | $                                                    | 1,318      |   | $ | 941 |   |
|                                                                                |       |                                                 |       |   |   |
| Other comprehensive income (loss) before tax, and  unrealized losses on securities: |       |                                                 |       |   |   |
| Unrealized gain (loss) on interest rate swaps used  in cash flow hedges             |       | (504                                                 | )          | (1,083 | ) |
| Unrealized gain (loss) on interest rate floors used  in cash flow hedges            |       | (224                                                 | )          | — |   |
| Unrealized gain (loss) on securities available for  sale                            |       | (796                                                 | )          | (425 | ) |
| Other comprehensive income (loss), before tax                                       |       | (1,524                                               | )          | (1,508 | ) |
|                                                                                |       |                                                 |       |   |   |
| Income tax benefit (expense) related to items of other  comprehensive income        |       | 444                                                  |       | 699 |   |
| Other comprehensive income (loss)                                                   |       | (1,080                                               | )          | (809 | ) |
| Total comprehensive income                                                          |       | $                                                    | 238        |   | $ | 132 |   |

 

NOTE 10—DERIVATIVEFINANCIAL INSTRUMENTS

 

The Company holds fixedrate and variable rate financial assets that are funded by fixed rate andvariable rate liabilities. Consequently, they are subject to the effects ofchanges in interest rates. In response to this, the Company has developed aninterest rate risk management policy with the objective of mitigating financialexposure to changing interest rates. These exposures are managed, in part, withthe use of derivatives but only to the extent necessary to meet the overallgoal of minimizing interest rate risk.

 

Derivatives are accountedfor according to SFAS No. 133, Accounting for Derivative Instruments andHedging Activities, as amended. This standard requires that all derivativeinstruments be recognized in the financial statements and measured at fairvalue regardless of the purpose or intent for holding them. To qualify forhedge accounting, the details of the hedging relationship must be formallydocumented at inception of the arrangement, including the risk managementobjective, hedging strategy, hedged item, specific risks that are being hedged,the derivative instrument and how effectiveness is being assessed. Thederivative must be highly effective in offsetting either changes in fair valueor cash flows, as appropriate, for the risk being hedged. Effectiveness isevaluated on a retrospective and prospective basis. If a hedge relationshipbecomes ineffective, it no longer qualifies as a hedge. Any excess gains orlosses attributable to such ineffectiveness, as well as subsequent changes inthe fair value of the derivative, are recognized in earnings.

 

13

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The following is asummary of our risk management strategies and the effect of these strategies onthe consolidated financial statements.

 
| **Derivative Financial Instruments and  Hedging Activities** | ** ** |
|--------------------------------------------------------------|------------|
|                                                         | ** ** |
| ** **                                                   | ** ** | **March 31, 2006** | ** ** | **December 31, 2005** | ** ** |
| ** **                                                   | ** ** | **Notional  Amount** | ** ** | **Fair Value** | ** ** | **Notional  Amount** | ** ** | **Fair Value** | ** ** |
| ** **                                                   | ** ** | **(Dollars in thousands)** | ** ** |
| Fair value hedges:                                           |       |   |   |   |   |   |   |   |   |
| Interest rate swaps                                          |       | $ | 75,000 |   | $ | (1,023 | ) | $ | 45,000 |   | $ | (575 | ) |
|                                                         |       |   |   |   |   |   |   |   |   |
| Cash flow hedges:                                            |       |   |   |   |   |   |   |   |   |
| Interest rate swaps                                          |       | $ | 50,000 |   | $ | (1,537 | ) | $ | 50,000 |   | $ | (1,034 | ) |
| Interest rate floors                                         |       | $ | 50,000 |   | $ | 45 |   | $ | 50,000 |   | $ | 268 |   |
|                                                         |       |   |   |   |   |   |   |   |   |
| Other derivatives:                                           |       |   |   |   |   |   |   |   |   |
| Interest rate floors                                         |       | $ | 150,000 |   | $ | — |   | $ | 150,000 |   | $ | — |   |

 

Fair value hedges arehedges that minimize the risk of changes in the fair values of assets,liabilities and certain types of firm commitments. The Company uses interestrate swaps to hedge the change in fair value of its junior subordinateddeferrable interest debentures. The interest rate swaps result in the Companypaying or receiving the difference between the fixed and floating rates atspecified intervals calculated on the notional amounts. The differential paidor received on such interest rate swaps are recognized as an adjustment tointerest expense. The net change in fair value of the derivatives and thehedged items is reported in earnings. The fair value hedges are highlyeffective and therefore no ineffectiveness was recognized in current earningsrelated to this swap.

 

Cash flow hedges arehedges that use simple derivatives to offset the variability of expected futurecash flows. The Company’s cash flow hedges include certain interest rate swapsand interest rate floors used to manage the interest rate risk associated withits significant volume of adjustable rate loans. At March 31, 2006, a lossof $1.5 million was recorded in accumulated other comprehensive income and noineffectiveness was recorded to earnings for the three months ended March 31,2006 related to these interest rate swaps. At March 31, 2005, a loss of $224,000was recorded in accumulated other comprehensive income related to the interestrate floors and no ineffectiveness was recorded to earnings for the threemonths ended March 31, 2005 related to these interest rate floors.

 

14

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Other derivatives notdesignated as hedges are interest rate floors that do not meet the strictcriteria for hedge accounting treatment. We use derivatives to hedge exposureswhen it makes economic sense to do so, including circumstances in which thehedging relationship does not qualify for hedge accounting. Derivatives notdesignated as hedges are marked to market through earnings. There was no chargeto earnings during the first quarter 2006 and 2005.

 

NOTE 11—RECLASSIFICATIONS

 

Certain prior year datahas been reclassified to conform to the current year presentation.

 

15

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***Item 2.******                     ******MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS***

 

NationalMercantile Bancorp (“National Mercantile” on a parent-only basis, and the “Company”on a consolidated basis) is the holding company for two subsidiary banks,Mercantile National Bank (“Mercantile”) and South Bay Bank, N.A. (“South Bay”)(collectively, “the Banks”). National Mercantile’s principal assets are thecapital stock of Mercantile and South Bay. The per share data reflects thefive-for-four stock split paid April 14, 2006 to shareholders of record March 31,2006 as well as the conversion of the Series A Preferred stock to commonstock in June 2005.

 

**RESULTS OF OPERATIONS OVERVIEW**

 

We recorded netincome of $1.3 million, or $0.24 basic earnings per share and $0.22 dilutedearnings per share, for the three months ended March 31, 2006 compared tonet income of $941,000, or $0.25 basic earnings per share and $0.16 dilutedearnings per share, for the same period of 2005. The increase in net income forthe first quarter of 2006 was primarily due to a $898,000 increase in netinterest income before the provision for credit losses resulting from increasesin the prime rate lending index, a greater volume of interest earning assets,particularly higher-yielding loans receivable and securitiesavailable-for-sale, and a favorable change in earning asset and fundingliability composition. This increase in net interest income for the firstquarter of 2005 was partially offset by a $246,000 increase in noninterestexpense. The Company adopted Statement of Financial Accounting Standards No. 123R,Stock-Based Payments (SFAS 123R), January 1, 2006 resulting in therecognition of compensation expense for unvested stock options and an after-taxcharge of $85,000 to earnings.

 

Return on averageassets during the first quarter of 2006 was 1.16% compared to 0.96% during the firstquarter of 2005. Return on average equity during the first quarter of 2006 was 13.51%compared to 10.80% during the first quarter of 2005.

 

NET INTEREST INCOME

 

Net interest incomeincreased $898,000 to $5.8 million during the first quarter of 2006 compared tofirst quarter 2005 due to a $2.2 million increase in interest income offset bya $1.3 million increase in interest expense.

 

Loan interest incomeincreased $1.6 million due to $34.0 million greater average volume of loansreceivable and a 118 basis point increase in yield, resulting primarily fromincreases in the prime rate lending index. During the second half of 2004, theFederal Reserve Bank increased interest rates 125 basis points on fiveoccasions after a prolonged period of accommodative monetary policy in responseto signs of stronger economic activity and perceived higher inflation risk. During

 

16

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2005, the Federal ReserveBank increased interest rates 200 basis points on eight occasions and, continuinginto the first quarter of 2006, another 50 basis points on two occasions. Approximately75% of our $353.5 million loans receivable at March 31, 2006, haveadjustable interest rates; consequently, rising interest rates positivelyaffect interest income. Conversely, declining interest rate environments havethe potential to negatively impact our net interest income. In order to reducethe negative impact in the event of a decline in the prime rate lending index,we have entered into interest rate swaps, in which we exchanged an adjustablerate interest payment based on the prime rate lending index for a fixed ratepayment on an aggregate notional amount of $50.0 million. The higher yieldsearned on our loans receivable during the first quarter of 2006 were partiallyoffset by the rising cost of the interest rate swaps.

 

Interest income fromsecurities available-for-sale increased $625,000 during the first quarter of2006 compared to the same period of 2005 due to $37.8 million greater averagevolume and a 159 basis point increase in yield. During the third and fourthquarter of 2005 and continuing into 2006, we have steadily added newlypurchased securities to our investment portfolio as part of a strategy tofurther reduce the exposure of net interest income to a declining interest rateenvironment. The additions to securities have been instruments that we expectto have limited prepayment of principal in the event of declining interestrates (and muted term extension in rising interest rates). These investments,as well as loans receivable, have been largely financed with adjustable ratewholesale funds that will decline in cost in a falling interest rateenvironment. The more recently purchased securities, in a period of higherinterest rates, and the maturity of lower yielding securities in the portfolio,resulted in an increase in the portfolio yield.

 

Overall, interest-earningassets were $64.0 million greater during 2006 period than 2005 while the higherinterest rates and favorable change in composition to higher-yielding assetsresulted in a 112 basis point increase in weighted average yield oninterest-earning assets.

 

Interest expenseincreased $1.3 million during the first quarter of 2006 compared to the sameperiod in 2005 due to a $63.5 million increase in average interest-bearingliabilities and a 141 basis point increase in the weighted average cost ofinterest-bearing liabilities. Interest expense on deposits increased $1.0million due to a 133 basis point rise in weighted average cost ofinterest-bearing deposits in addition to $46.0 million greater average volumethan 2004. Time certificates of deposit $100,000 and over averaged $41.0million greater during the 2006 period than 2005 due to an increased volume ofbrokered certificates of deposit (“Brokered CDs”). The volume of money marketand savings deposits increased $7.8 million during the first quarter of 2006compared to first quarter of 2005 while time certificates of deposit under $100,000declined $3.6 million.

 

17

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During the risinginterest rate environment experienced during the past six quarters, westrategically elected to only moderately increase transaction deposit rates andto fund asset growth, and runoff of these deposits, with Brokered CDs. Althoughthis type of funding is typically higher costing and exhibits higher interestrate sensitivity, the Brokered CDs facilitate our liquidity and interest raterisk management that we utilize to reduce our net interest income exposure topossible declining interest rates. The greater interest expense on theincremental Brokered CDs needed to fund asset growth is less than the impact ofincreasing rates on the significantly greater volume of transaction accounts. Asmarket interest rates continue to rise, the cost of our deposits has beenincreasing more rapidly due to more frequent exceptions to our posted interestrates granted to depositors in order to prevent deposit withdrawals.

 

The cost of timecertificates of deposit $100,000 and over increased 175 basis points during thefirst quarter of 2006 compared to first quarter 2005. The cost of money marketand savings deposits increased 127 basis points while the cost of interest-bearingdemand deposits and time certificates of deposit under $100,000 increased 11basis points and 87 basis points, respectively.

 

The volume of otherborrowings averaged $20.3 million and $15.1 million during the first quarter of2006 and 2005, respectively. We continue to employ a liquidity strategy ofmaintaining relatively low levels of short-term assets and utilizing FederalHome Loan Bank overnight advances, against pledged loans and securities, tofund asset and deposit fluctuations. Minimizing short-term assets andincreasing short-term liabilities furthers the interest rate risk management ofour asset sensitive balance sheet. The cost of other borrowings was 4.48% and2.52% for 2005 and 2004 periods, respectively, representing an increase of 196basis points for the first quarter of 2006.

 

In 2001, we issued $15.5million of junior subordinated deferrable interest debentures (“JuniorSubordinated Debentures”) with a fixed interest rate of 10.25% due in 2031. Inorder to complement our asset sensitive balance sheet, during 2003 we enteredinto an interest rate swap in which we exchanged a fixed rate payment for anadjustable rate interest payment based on the LIBOR index on an aggregatenotional amount of $15.0 million. The cost of the Junior Subordinated Debentureswas 9.26% and 7.34% during the first quarter of 2006 and 2005, respectively,reflecting the rising interest rate environment.

 

Securities sold underagreement to repurchase (“Repurchase Agreements”) averaged $12.3 million duringthe first quarter of 2006 with a cost of 4.77%. The Repurchase Agreements,total $15.0 million with an adjustable interest rate based upon the LIBOR indexand have an embedded floor with a strike rate of 4.0% maturing in January 2008,further our interest rate risk management objectives. In the event that theLIBOR index declines below the strike rate, the cost of the Repurchase 

 

18

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Agreements will declineat double the difference between the LIBOR index and the strike rate. We had noRepurchase Agreements during 2005.

 

Noninterest-bearingdemand deposits averaged $113.4 million during the first quarter 2006 or $8.0million less than during the same quarter in 2005. Rising interest ratesincrease depositors’ opportunity cost of noninterest-bearing deposits and theirsensitivity to maintaining such balances, resulting in the redeployment oftheir funds into higher yielding deposits and alternative investments outsidethe Banks.

 

The net yield on interestearning assets (net interest margin) was nearly flat at 5.49% and 5.45% duringthe first quarter in 2006 and 2005, respectively, while the net interest spreadwas 4.60% and 4.89%, respectively. The net interest margin and net interestspread during the first quarter of 2006 have declined from recent quarterslargely due to the securities leverage strategy – intermediate-term securitypurchases financed with short-term wholesale funds – executed to reduce ourbalance sheet asset sensitivity. Also, the first quarter of 2006 experienced a “flatyield curve” in which short-term rates have risen to the level of long-terminterest rates. A preponderance of our funding sources are correlated to theshort-term rates.

 

The following tablepresents the components of net interest income for the three months ended March 31,2006 and 2005.

 

19

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**Average Balance Sheet and Analysis of Net Interest Income**

 
| ** **                                                                                     | ** ** | **Three Months ended**     | ** ** |
|------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                     | ** ** | **March 31, 2006**         | ** ** | **March 31, 2005** | ** ** |
| ** **                                                                                     | ** ** | ** **                           | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                                                                                     | ** ** | ** **                           | ** ** | **Interest** | ** ** | **Average** | ** ** | ** ** | ** ** | **Interest** | ** ** | **Average** | ** ** |
| ** **                                                                                     | ** ** | **Average**                          | ** ** | **Income/** | ** ** | **Yield/** | ** ** | **Average** | ** ** | **Income/** | ** ** | **Yield/** | ** ** |
| ** **                                                                                     | ** ** | **Amount**                           | ** ** | **Expense** | ** ** | **Rate** | ** ** | **Amount** | ** ** | **Expense** | ** ** | **Rate** | ** ** |
| ** **                                                                                     | ** ** | **(Dollars in thousands)** | ** ** |
| Assets:                                                                                        |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Federal funds sold                                                                             |       | $                                    | 443        |   | 5 |   | 4.58 | % | $ | 1,667 |   | 10 |   | 2.43 | % |
| Due from banks-interest bearing                                                                |       | 2,000                                |       | 21 |   | 4.26 | % | 7,660 |   | 16 |   | 0.85 | % |
| Securities available-for-sale                                                                  |       | 77,729                               |       | 959 |   | 4.94 | % | 39,909 |   | 334 |   | 3.35 | % |
| Securities held-to-maturity                                                                    |       | 2,546                                |       | 26 |   | 4.08 | % | 3,415 |   | 34 |   | 3.98 | % |
| Loans receivable (1) (2)                                                                  |       | 342,737                              |       | 7,040 |   | 8.33 | % | 308,766 |   | 5,443 |   | 7.15 | % |
| Total interest earning assets                                                                  |       | 425,455                              |       | 8,051 |   | 7.67 | % | 361,417 |   | 5,837 |   | 6.55 | % |
|                                                                                           |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest earning assets:                                                                    |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks - demand                                                               |       | 15,020                               |       |   |   |   |   | 19,135 |   |   |   |   |   |
| Other assets                                                                                   |       | 23,635                               |       |   |   |   |   | 20,569 |   |   |   |   |   |
| Allowance for credit losses and net unrealized gain  on sales of securities available-for-sale |       | (5,229                               | )          |   |   |   |   | (4,066 | ) |   |   |   |   |
| Total assets                                                                                   |       | $                                    | 458,881    |   |   |   |   |   | $ | 397,055 |   |   |   |   |   |
|                                                                                           |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Liabilities and shareholders’ equity:                                                     |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing deposits:                                                                     |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Demand                                                                                         |       | $                                    | 32,909     |   | 42 |   | 0.52 | % | $ | 32,036 |   | 32 |   | 0.41 | % |
| Money market and savings                                                                       |       | 110,886                              |       | 584 |   | 2.14 | % | 103,132 |   | 220 |   | 0.87 | % |
| Time certificates of deposit:                                                                  |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| $100,000  or more                                                                              |       | 86,395                               |       | 768 |   | 3.61 | % | 45,433 |   | 208 |   | 1.86 | % |
| Under  $100,000                                                                                |       | 24,217                               |       | 176 |   | 2.95 | % | 27,767 |   | 142 |   | 2.07 | % |
| Total time certificates of deposit                                                             |       | 110,612                              |       | 944 |   | 3.46 | % | 73,200 |   | 350 |   | 1.94 | % |
| Total interest-bearing deposits                                                                |       | 254,407                              |       | 1,570 |   | 2.50 | % | 208,368 |   | 602 |   | 1.17 | % |
| Other borrowings                                                                               |       | 20,283                               |       | 224 |   | 4.48 | % | 15,139 |   | 94 |   | 2.52 | % |
| Junior subordinated debentures                                                                 |       | 15,464                               |       | 353 |   | 9.26 | % | 15,464 |   | 280 |   | 7.34 | % |
| Federal funds purchased and securities sold under  agreements to repurchase                    |       | 12,333                               |       | 145 |   | 4.77 | % | — |   | — |   | — |   |
| Total  interest-bearing liabilities                                                            |       | 302,487                              |       | 2,292 |   | 3.07 | % | 238,971 |   | 976 |   | 1.66 | % |
|                                                                                           |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing liabilities:                                                               |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing demand deposits                                                            |       | 113,413                              |       |   |   |   |   | 121,408 |   |   |   |   |   |
| Other liabilities                                                                              |       | 3,417                                |       |   |   |   |   | 1,349 |   |   |   |   |   |
| Shareholders’ equity                                                                      |       | 39,564                               |       |   |   |   |   | 35,327 |   |   |   |   |   |
| Total liabilities and shareholders’ equity                                                |       | $                                    | 458,881    |   |   |   |   |   | $ | 397,055 |   |   |   |   |   |
|                                                                                           |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income (spread)                                                                   |       |                                 |       | $ | 5,759 |   | 4.60 | % |   |   | $ | 4,861 |   | 4.89 | % |
|                                                                                           |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Net yield on earning assets (2)                                                                |       |                                 |       |   |   | 5.49 | % |   |   |   |   | 5.45 | % |
|                                                                                                |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)          Theaverage balance of nonperforming loans has been included in loans receivable.

(2)          Yieldsand amounts earned on loans receivable include loan fees of $341,000 and$423,000 for the three months ended March 31, 2006 and 2005, respectively.

 

20

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The followingtable sets forth, for the periods indicated, the changes in interest earned andinterest paid resulting from changes in volume and changes in rates. Averagebalances in all categories in each reported period were used in the volumecomputations. Average yields and rates in each reported period were used inrate computations. 

 

**Increase (Decrease) in Interest Income/Expense Due to Changein**

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

 
| ** **                                                                  | ** ** | **Three Months ended March 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                  | ** ** | **2006 vs 2005**                           | ** ** |
| ** **                                                                  | ** ** | ** **                                           | ** ** | ** ** | ** ** | **Net** | ** ** |
| ** **                                                                  | ** ** | **Increase (decrease) due to:**       | ** ** | **Increase** | ** ** |
| ** **                                                                  | ** ** | **Volume**                                           | ** ** | **Rate** | ** ** | **(Decrease)** | ** ** |
| ** **                                                                  | ** ** | **(Dollars in thousands)**                 | ** ** |
| Interest Income:                                                            |       |                                                 |       |   |   |   |   |
| Federal funds sold                                                          |       | $                                                    | (7         | ) | $ | 2 |   | $ | (5 | ) |
| Interest-bearing deposits with other financial  institutions                |       | (12                                                  | )          | 17 |   | 5 |   |
| Securities available-for-sale                                               |       | 317                                                  |       | 308 |   | 625 |   |
| Securities held-to-maturity                                                 |       | (9                                                   | )          | 1 |   | (8 | ) |
| Loans receivable (2)                                                        |       | 599                                                  |       | 998 |   | 1,597 |   |
| Total interest-earning assets                                               |       | 888                                                  |       | 1,326 |   | 2,214 |   |
|                                                                        |       |                                                 |       |   |   |   |   |
| Interest Expense:                                                           |       |                                                 |       |   |   |   |   |
| Interest-bearing deposits:                                                  |       |                                                 |       |   |   |   |   |
| Demand                                                                      |       | $                                                    | 1          |   | $ | 9 |   | $ | 10 |   |
| Money market and savings                                                    |       | 17                                                   |       | 347 |   | 364 |   |
| Time certificates of deposit:                                               |       |                                                 |       |   |   |   |   |
| $100,000 or more                                                            |       | 188                                                  |       | 372 |   | 560 |   |
| Under $100,000                                                              |       | (18                                                  | )          | 52 |   | 34 |   |
| Total time certificates of deposit                                          |       | 170                                                  |       | 424 |   | 594 |   |
| Total interest-bearing deposits                                             |       | 188                                                  |       | 780 |   | 968 |   |
| Other borrowings                                                            |       | 32                                                   |       | 98 |   | 130 |   |
| Junior subordinated debentures                                              |       | —                                               |       | 73 |   | 73 |   |
| Federal funds purchased and securities sold under  agreements to repurchase |       | 145                                                  |       | — |   | 145 |   |
| Total interest-bearing liabilities                                          |       | 365                                                  |       | 951 |   | 1,316 |   |
|                                                                        |       |                                                 |       |   |   |   |   |
| Net interest income                                                         |       | $                                                    | 523        |   | $ | 375 |   | $ | 898 |   |

 

----

(1) The change in interest income or interest expensethat is attributable to both changes in average balance, average rate and daysin the quarter has been allocated to the changes due to (i) averagebalance and (ii) average rate in proportion to the relationship of theabsolute amounts of changes in each.

(2) Table does not include interest income that wouldhave been earned on nonaccrual loans.

 

PROVISION FOR CREDITLOSSES

 

We recorded a provisionfor credit losses of $32,000 for the first quarter 2006, reflecting the growthin loans receivable partially offset by a decrease in unfunded loancommitments, compared to $89,000 for the first quarter 2005. During the first quarter2006, we charged off loans receivable of $1,000.

 

21

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OTHER OPERATING INCOME

 

Other operatingincome was $322,000 during both the first quarter of 2006 and 2005. Deposit-relatedfees decreased in the 2006 period due to higher compensating balance rates andchanges in fee structure. This decline was offset by a $48,000 gain on the saleof other real estate owned acquired through foreclosure and an increase ininternational services fees.

 

OTHER OPERATING EXPENSES

 

Other operating expenses increased to$3.7 million for the three months ended March 31, 2006 compared to $3.5million for the same period of 2005. Significant variances withinoperating expenses were: (i) salaries and related benefits expense increased$251,000 or 13.7% due to the adoption of SFAS 123R requiring stock options tobe expensed, the addition of business development staff and increased incentiveexpense; (ii) legal services expense decreased $74,000 or 50.7% primarilydue to fewer problem assets and the decline in related legal activity; and (iii) otherprofessional services expense increased $50,000 or 19.7% due to increased costsfor audit services, recruiting fees and directors’ fees.

 

***BALANCE SHEET ANALYSIS***

 

INVESTMENTSECURITIES

 

Thefollowing comparative period-end table sets forth certain informationconcerning the estimated fair values and unrealized gains and losses ofsecurities available-for-sale and securities held-to-maturity.

 

22

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**Estimated Fair Values of and Unrealized**

**Gains and Losses on Securities**

 
| ** **                                                                | ** ** | **March 31, 2006**         | ** ** |
|---------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                | ** ** | **Total**                            | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                                                                | ** ** | **amortized**                        | ** ** | **unrealized** | ** ** | **unrealized** | ** ** | **fair** | ** ** |
| ** **                                                                | ** ** | **cost**                             | ** ** | **gains** | ** ** | **loss** | ** ** | **value** | ** ** |
| ** **                                                                | ** ** | **(Dollars in thousands)** | ** ** |
| **Available-for-Sale:**                                                   |       |                                 |       |   |   |   |   |   |   |
| U.S. Treasury securities                                                  |       | $                                    | 599        |   | $ | — |   | $ | 3 |   | $ | 596 |   |
| GNMA-issued/guaranteed mortgage pass through  certificates                |       | 89                                   |       | 1 |   | — |   | 90 |   |
| Other U.S. Government and federal agency securities                       |       | 9,036                                |       | — |   | 109 |   | 8,927 |   |
| FHLMC/FNMA-issued mortgage pass through certificates                      |       | 49,793                               |       | 38 |   | 934 |   | 48,897 |   |
| CMO’s and REMIC’s issued by U.S.  government-sponsored agencies |       | 2,526                                |       | — |   | 1 |   | 2,525 |   |
| Privately issued corporate bonds, CMO and REMIC  securities               |       | 25,235                               |       | — |   | 445 |   | 24,790 |   |
|                                                                      |       | $                                    | 87,278     |   | $ | 39 |   | $ | 1,492 |   | $ | 85,825 |   |
|                                                                      |       |                                 |       |   |   |   |   |   |   |
| FRB and other equity stocks                                               |       | $                                    | 3,940      |   | — |   | — |   | $ | 3,940 |   |

 
| ** **                                           | ** ** | **March 31, 2006**    | ** ** |
|------------------------------------------------------|------------|----------------------------|------------|
| ** **                                           | ** ** | **Total**                  | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                                           | ** ** | **amortized**              | ** ** | **unrealized** | ** ** | **unrealized** | ** ** | **fair** | ** ** |
| ** **                                           | ** ** | **cost**                   | ** ** | **gains** | ** ** | **loss** | ** ** | **value** | ** ** |
| ** **                                           | ** ** | **(Dollars in thousands)** | ** ** |
| **Held-to-Maturity:**                                |       |                       |       |   |   |   |   |   |   |
| FHLMC/FNMA-issued mortgage pass through certificates |       | $                          | 2,438      |   | $ | — |   | $ | 68 |   | $ | 2,370 |   |
|                                                 |       | $                          | 2,438      |   | $ | — |   | $ | 68 |   | $ | 2,370 |   |

 
| ** **                                                                | ** ** | **December 31, 2005** | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                | ** ** | **Total**                  | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                                                                | ** ** | **amortized**              | ** ** | **unrealized** | ** ** | **unrealized** | ** ** | **fair** | ** ** |
| ** **                                                                | ** ** | **cost**                   | ** ** | **gains** | ** ** | **loss** | ** ** | **value** | ** ** |
| ** **                                                                | ** ** | **(Dollars in thousands)** | ** ** |
| **Available-For-Sale:**                                                   |       |                       |       |   |   |   |   |   |   |
| U.S. Treasury securities                                                  |       | $                          | 599        |   | $ | — |   | $ |   |   | $ | 599 |   |
| GNMA-issued/guaranteed mortgage pass through  certificates                |       | 98                         |       | 2 |   | — |   | 100 |   |
| Other U.S. government and federal agency securities                       |       | 17,931                     |       | — |   | 152 |   | 17,779 |   |
| FHLMC/FNMA-issued mortgage pass through certificates                      |       | 33,982                     |       | 47 |   | 366 |   | 33,663 |   |
| CMO’s and REMIC’s issued by U.S.  government-sponsored agencies |       | 2,528                      |       | 13 |   | — |   | 2,541 |   |
| Privately issued corporate bonds, CMO and REMIC  securities               |       | 17,290                     |       | 3 |   | 217 |   | 17,076 |   |
|                                                                      |       | $                          | 72,428     |   | $ | 65 |   | $ | 735 |   | $ | 71,758 |   |
|                                                                      |       |                       |       |   |   |   |   |   |   |
| FRB and other equity stocks                                               |       | $                          | 3,809      |   | — |   | — |   | $ | 3,809 |   |
|                                                                           |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                           | ** ** | **December 31, 2005** | ** ** |
|------------------------------------------------------|------------|----------------------------|------------|
| ** **                                           | ** ** | **Total**                  | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                                           | ** ** | **amortized**              | ** ** | **unrealized** | ** ** | **unrealized** | ** ** | **fair** | ** ** |
| ** **                                           | ** ** | **cost**                   | ** ** | **gains** | ** ** | **loss** | ** ** | **value** | ** ** |
| ** **                                           | ** ** | **(Dollars in thousands)** | ** ** |
|                                                 |       |                       |       |   |   |   |   |   |   |
| **Held-to-Maturity:**                                |       |                       |       |   |   |   |   |   |   |
| FHLMC/FNMA-issued mortgage pass through certificates |       | $                          | 2,612      |   | $ |   |   | $ | 40 |   | $ | 2,572 |   |
|                                                 |       | $                          | 2,612      |   | $ | — |   | $ | 40 |   | $ | 2,572 |   |

 

23

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As of March 31, 2006, we did nothold securities of any issuer, other than U.S. government-chartered agencies,the aggregate book value of which exceeded 10% of our shareholders’ equity. At March 31,2006 and December 31, 2005, we had no securities determined to beother-than-temporarily impaired.

 

LOANPORTFOLIO

 

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

 

**Loan Portfolio Composition**

 
| ** **                                                            | ** ** | **March 31,**                   | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------|------------|
| ** **                                                            | ** ** | **2006**                             | ** ** | **2005**              | ** ** |
| ** **                                                            | ** ** | **Amount**                           | ** ** | **Percent**           | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **                                                            | ** ** | **(Dollars in thousands)** | ** ** |
| Commercial loans - secured and unsecured                              |       | $                                    | 91,928     |                  | 26         | % | $ | 89,474 |   | 26 | % |
| Real estate loans:                                                    |       |                                 |       |                  |       |   |   |   |   |
| Secured by commercial real properties                                 |       | 132,542                              |       | 37                    | %          | 121,641 |   | 36 | % |
| Secured by one to four family residential properties                  |       | 9,279                                |       | 3                     | %          | 10,498 |   | 3 | % |
| Secured by multifamily residential properties                         |       | 18,828                               |       | 5                     | %          | 18,663 |   | 6 | % |
| Total real estate loans                                               |       | 160,649                              |       | 45                    | %          | 150,802 |   | 45 | % |
| Construction and land development                                     |       | 94,629                               |       | 27                    | %          | 92,077 |   | 27 | % |
| Consumer installment, home equity and unsecured  loans to individuals |       | 7,289                                |       | 2                     | %          | 7,239 |   | 2 | % |
| Total loans outstanding                                               |       | 354,495                              |       | 100                   | %          | 339,592 |   | 100 | % |
|                                                                  |       |                                 |       |                  |       |   |   |   |   |
| Deferred net loan origination fees                                    |       | (995                                 | )          |                  |       | (1,034 | ) |   |   |
| Loans receivable, net                                                 |       | $                                    | 353,500    |                  |       |   | $ | 338,558 |   |   |   |

 

Loans receivable increased$14.9 million to $353.5 million at March 31, 2006 compared to $338.6million at December 31, 2005 primarily due to increased funding of commercialreal estate loans, secured and unsecured commercial loans and construction loans.We have increased funding of intermediate-term fixed rate commercial realestate loans as part of our interest rate risk management strategy.

 

NONPERFORMING ASSETS

 

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

 

24

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**Nonperforming Assets**

 
| ** **                                                                                                                 | ** ** | **March 31,**                   | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                 | ** ** | **2006**                             | ** ** | **2005**              | ** ** |
| ** **                                                                                                                 | ** ** | **(Dollars in thousands)** | ** ** |
|                                                                                                                       |       |                                 |       |                  |       |
| Nonaccrual loans                                                                                                           |       | $                                    | 300        |                  | $          | 319 |   |
| Troubled debt restructurings                                                                                               |       | —                               |       | —                |       |
| Loans contractually past due ninety or more days  with respect to either principal or interest and still accruing interest |       | —                               |       |                  |       |
| Nonperforming loans                                                                                                        |       | 300                                  |       | 319                   |       |
| Other real estate owned                                                                                                    |       | —                               |       | 1,056                 |       |
| Other nonperforming assets                                                                                                 |       | —                               |       | —                |       |
| Total nonperforming assets                                                                                                 |       | $                                    | 300        |                  | $          | 1,375 |   |
|                                                                                                                       |       |                                 |       |                  |       |
| Allowance for credit losses as a percent of  nonaccrual loans                                                              |       | 1520.7                               | %          | 1400.6                | %          |
| Allowance for credit losses as a percent of  nonperforming loans                                                           |       | 1520.7                               | %          | 1400.6                | %          |
| Total nonperforming assets as a percent of loans  receivable                                                               |       | 0.1                                  | %          | 0.4                   | %          |
| Total nonperforming assets as a percent of total  shareholders’ equity                                                |       | 0.8                                  | %          | 3.6                   | %          |

 

During the first quarterof 2006, we sold other real estate owned recording a $48,000 gain on sale. A singlesecured commercial loan was on nonaccrual status due to borrower financialweakness and uncertainty surrounding collateral value. The loan was originatedas part of a settlement of a legal dispute and is current by way ofadvances from an interest reserve, typical for this type of financing. Theborrower’s ability to repay our loan is highly dependent upon its success inmarketing certain distribution rights.

 

ALLOWANCE FOR CREDIT LOSSES

 

The adequacy of theallowance for credit losses is determined through periodic analysis of the loanportfolio. This analysis includes a systematic and detailed review of theclassification and categorization of problem loans; an assessment of theoverall quality and collectibility of the portfolio; and consideration of theloan loss experience, trends in problem loans, concentrations of credit risk,as well as current economic conditions (particularly Southern California). Managementperforms a periodic risk and credit analysis, the results of which are reportedto the Board of Directors.

 

We charged off $1,000 ofloans during the first quarter of 2006, compared to $6,000 of loans charged offduring the first quarter of 2005. There were no recoveries of loans previouslycharged off during the first quarter of 2006, respectively, compared to $3,000during the first quarter of 2005. Pursuant to our evaluation of the allowancefor credit losses at March 31, 2006, we recorded a provision for creditlosses of $32,000 for the first quarter 2006.

 

Credit quality isaffected by many factors beyond the control of the Company, including local andnational economies, and facts may exist which are not known to the Companythat adversely affect the likelihood of repayment of various loans in 

 

25

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the loan portfolio andrealization 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, as an integral part of its examination process, periodicallyreviews the allowance for credit losses and could require additional provisionsfor credit losses.

 

DEPOSITS

 

Total depositswere $405.4 million and $363.2 million at March 31, 2006 and December 31,2005, respectively. Noninterest-bearing demand deposits increased to $122.6million at March 31, 2006 compared to $115.9 million at December 31,2005. Our noninterest-bearing demand deposits experience significantvariability and seasonality due to the nature of our depositors’ businesses andthe cash needs of our business customers for quarterly tax payments and ownerdistributions. Noninterest-bearing demand deposits declined significantly at December 31,2005 from the fourth quarter average of $122.8 million; thus the increase at March 31,2006 reflected a normalization following this year-end variability. Moneymarket deposits and savings deposits were $91.9 million and $26.3 million,respectively, at March 31, 2006 compared to $76.3 million and $28.2million, respectively, at December 31, 2005. Interest-bearing demanddeposits, which for the most part are limited to individuals, decreased to$31.7 million at March 31, 2006 from $36.0 million at December 31,2005. Interest-bearing demand deposits increased significantly at December 31,2005 from the fourth quarter average of $32.6 million, thus the decline at March 31,2006 reflected a normalization following the year-end variability. Timecertificates of deposit increased to $132.8 million at March 31, 2006 from$106.7 million at December 31, 2005 due to an increase in brokereddeposits. We had $60 million in brokered time certificates of deposit at March 31,2006 compared to $37.5 million at December 31, 2005.

 

Additionally, although wehave priced our retail certificates of deposit to encourage runoff during thepast several years, in the rising rate environment experienced during the past7 quarters, we have elected to only moderately increase rates on itsimmediately repriceable base of deposits – interest-bearing demand deposits,and savings and money market deposits – and price new time certificates ofdeposit to generate growth.

 

In a sustained risinginterest rate environment, increases in deposit interest rates will be requiredto prevent net deposit withdrawals. Additionally, in order to generate newdeposit growth, we have paid significantly higher rates than that paid onexisting deposits.

 

26

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SECURITIES SOLD UNDERAGREEMENTS TO REPURCHASE

 

Securities sold underagreements to repurchased (“Repurchase Agreements”) totaled $15.0 million at March 31,2006. We entered into the Repurchase Agreements to further our liquidity andinterest rate sensitivity objectives. The Repurchase Agreements are adjustablerate and contain embedded interest rate floors that will result in an exponentialdecline in cost in the event of a sustained decline in interest rates. Theembedded interest rate floors are clearly and closely related to the economiccharacteristics and risks of the underlying Repurchase Agreements andaccordingly are not separated and accounted for as derivative instruments. Wehad no repurchase agreements at December 31, 2005.

 

OTHER BORROWINGS

 

There were $1.4 million of other borrowings,consisting of advances from the Federal Home Loan Bank, at March 31, 2006compared to $28.3 million at December 31, 2005. The decline in otherborrowings reflected repayment with alternative wholesale funding sources,including brokered time certificates of deposit and Repurchase Agreements.

 

SHAREHOLDERS’ EQUITY

 

Shareholders’ equityincreased from $38.5 million at December 31, 2005 to $39.3 million at March 31,2006 due to the retained earnings for the three months ended March 31,2006 partially offset by a decrease in market value of interest rate swaps andsecurities available-for-sale.

 

***CAPITALADEQUACY REQUIREMENTS***

 

At March 31, 2006, NationalMercantile and the Banks were in compliance with all applicable regulatorycapital requirements and the Banks were “well capitalized” under the PromptCorrective Action rules of the OCC. The following table sets forth theregulatory capital standards for well-capitalized institutions, and the capitalratios for National Mercantile and the Banks, as of March 31, 2006 and December 31,2005.

 

27

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**Regulatory Capital Information of the National MercantileBancorp and Banks**

 
| ** **                       | ** ** | **Minimum**          | ** ** | ** **      | ** ** | ** **         | ** ** | ** **            | ** ** |
|----------------------------------|------------|----------------------|------------|-----------------|------------|--------------------|------------|-----------------------|------------|
| ** **                       | ** ** | **For Capital** | ** ** | **Well**        | ** ** | ** **         | ** ** | ** **            | ** ** |
| ** **                       | ** ** | **Adequacy**         | ** ** | **Capitalized** | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
| ** **                       | ** ** | **Purposes**         | ** ** | **Standards**   | ** ** | **2006**           | ** ** | **2005**              | ** ** |
| **National Mercantile Bancorp:** |       |                 |       |            |       |               |       |                  |       |
| Tier 1 leverage                  |       | 4.00                 | %          | N/A             |       | 10.82              | %          | 10.80                 | %          |
| Tier 1 risk-based capital        |       | 4.00                 | %          | N/A             |       | 12.88              | %          | 12.06                 | %          |
| Total risk-based capital         |       | 8.00                 | %          | N/A             |       | 14.13              | %          | 13.87                 | %          |
|                             |       |                 |       |            |       |               |       |                  |       |
| **Mercantile National Bank:**    |       |                 |       |            |       |               |       |                  |       |
| Tier 1 leverage                  |       | 4.00                 | %          | 5.00            | %          | 10.47              | %          | 10.49                 | %          |
| Tier 1 risk-based capital        |       | 4.00                 | %          | 6.00            | %          | 12.88              | %          | 13.59                 | %          |
| Total risk-based capital         |       | 8.00                 | %          | 10.00           | %          | 14.13              | %          | 14.84                 | %          |
|                             |       |                 |       |            |       |               |       |                  |       |
| **South Bay Bank, NA:**          |       |                 |       |            |       |               |       |                  |       |
| Tier 1 leverage                  |       | 4.00                 | %          | 5.00            | %          | 8.98               | %          | 9.04                  | %          |
| Tier 1 risk-based capital        |       | 4.00                 | %          | 6.00            | %          | 9.32               | %          | 9.00                  | %          |
| Total risk-based capital         |       | 8.00                 | %          | 10.00           | %          | 10.54              | %          | 10.22                 | %          |

 

***LIQUIDITY***

 

We manage ourliquidity through a combination of core deposits, federal funds purchased,repurchase agreements, collateralized borrowing lines, and a portfolio ofsecurities available for sale. Liquidity is also provided by maturinginvestment securities and loans.

 

Our cash and duefrom banks - demand was $15.2 million on March 31, 2006 compared to $13.5million on December 31, 2005. Due from banks-interest-bearing was $2.0million at March 31, 2006 and December 31, 2005. There was $2.8million in Federal funds sold at March 31, 2006 compared to $685,000 at December 31,2005. Mercantile had $12.5 million and South Bay had $10.0 million in Federalfunds borrowing lines with correspondent banks as of March 31, 2006. Additionally,at March 31, 2006 we had $73.4 million remaining borrowing capacity at theFHLB against pledged loans and securities.

 

National Mercantile is alegal entity separate and distinct from the Banks and, therefore, it mustprovide for its own liquidity. National Mercantile’s principal sources of fundsare proceeds from the sales of securities and dividends or capitaldistributions from the Banks. In addition to funding its own operatingexpenses, National Mercantile is responsible for the payment of the interest onthe outstanding Junior Subordinated Debentures. The semiannual interestpayments on the Junior Subordinated Debentures are deferrable at NationalMercantile’s option, for a period up to ten consecutive semiannual payments,but in any event not beyond June 25, 2031. National Mercantile has notdeferred any interest payments.

 

National Mercantile’scash and due from banks, including interest-bearing, was $628,000 on March 31,2006.

 

28

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Dividends andcapital distributions from the Banks constitute the principal ongoing source ofcash to National Mercantile. The Banks are subject to various statutory andregulatory restrictions on their ability to pay dividends and capitaldistributions to National Mercantile.

 

OCC approval isrequired for a national bank to pay a dividend if the total of all dividendsdeclared in any calendar year exceeds the total of the bank’s net profits (asdefined) for that year combined with its retained net profits for the precedingtwo calendar years, less any required transfer to surplus or a fund for theretirement of any preferred stock. A national bank may not pay anydividend that exceeds its retained net earnings, as defined by the OCC. The OCCand the Federal Reserve have also issued banking circulars emphasizing that thelevel of cash dividends should bear a direct correlation to the level of anational bank’s current and expected earnings stream, the bank’s need tomaintain an adequate capital base and other factors.

 

National banksthat are not in compliance with regulatory capital requirements generally arenot permitted to pay dividends. The OCC also can prohibit a national bank fromengaging in an unsafe or unsound practice in its business. Depending on thebank’s financial condition, payment of dividends could be deemed to constitutean unsafe or unsound practice. Except under certain circumstances, and withprior regulatory approval, a bank may not pay a dividend if, after so doing,it would be undercapitalized. A bank’s ability to pay dividends in the futureis, and could be, further influenced by regulatory policies or agreements andby capital guidelines.

 

Mercantile has anaccumulated deficit and does not anticipate having positive cumulative retainedearnings until 2008 at the current rate of earnings. South Bay had cumulativeretained earnings of $3.8 million as of March 31, 2006. Mercantile andSouth Bay may from time to time be permitted to make capital distributionsto National Mercantile with the consent of the OCC. It is likely that suchconsent could not be obtained unless the distributing bank remained “wellcapitalized” following such distribution.

 

***ASSETLIABILITY MANAGEMENT***

 

We manage interestrate sensitivity by matching the repricing opportunities on our earning assetsto those on our funding liabilities. Various strategies are used to manage therepricing characteristics of assets and liabilities to ensure that exposure tointerest rate fluctuations is limited within guidelines of acceptable levels ofrisk-taking. Hedging strategies, including the terms and pricing of loans anddeposits, the use of derivative financial instruments (see Note 10 of the Notesto the Consolidated Financial Statements) and managing the deployment ofsecurities are used to reduce mismatches in interest rate repricingopportunities of portfolio assets and their funding sources. Interest rate riskis measured using financial modeling techniques, 

 

29

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including stress tests,to measure the impact of changes in interest rates on future earnings. Thesestatic measurements do not reflect the results of any projected activity andare best used as early indicators of potential interest rate exposures.

 

The Company’s interestrate sensitivity position during a period of moderate rising interest rates isexpected to have a positive impact on net interest income due to the Company’slarge base of noninterest-bearing deposits as well as interest rates paid onfunding liabilities typically change in smaller magnitude compared to changesin the yield of its substantial adjustable earning assets. Since interest ratesbegan increasing in June 2004, the Company’s net interest income has infact significantly increased with funding costs lagging the increase in earningasset yields. This lag in funding costs could narrow future net interestmargins in the event that rates paid on deposits begin rising more rapidly dueto increased funding needs or competitive pressures.

 

In a period ofdeclining rates, such as the environment that was experienced during 2001 and2002, the decline is expected to have a negative effect on the Company’s netinterest income as changes in the rates of interest-bearing deposits historicallyhave not changed in similar magnitude to changes in market interest rates. Additionally,in relatively low and declining interest rate environments, the interest ratespaid on funding liabilities may begin to reach floors preventing furtherdownward adjustments while rates on earning assets continue to adjust downward.To partially mitigate the negative effects of declining interest rates on itsnet interest margin, during the third quarter 2005 the Company accelerated itspurchases of intermediate term investment securities which were partly fundedby short-term liabilities. Additionally, the Company has entered into interestrate swap agreements and has purchased interest rate floors at various strikeprices and terms that have the effect of further reducing its exposure todeclining interest rates.

 

# **FACTORS WHICH MAY AFFECTFUTURE OPERATING RESULTS**

# ** **

The Company’s results of operations and financialcondition are affected by many factors, including the following:

 

**Risk from changes in interest rates.**

 

The success of the Company’s business depends, to alarge extent, on its net interest income. Changes in market interest rates canaffect net interest income by affecting the spread between interest-earningassets and interest-bearing liabilities. This may be due to the differentmaturities of interest-earning assets and interest-bearing liabilities, as wellas an increase in the general level of interest rates. Changes in marketinterest rates also affect, among other things:

 

•                  The Company’sability to originate loans;

 

•                  The abilityof borrowers to make payments on their loans;

 

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

 

•                  The averagelife of interest-earning assets;

 

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

 

•                  The 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 the Company’s control.

 

**Risk from possible declines in the quality of theCompany’s assets.**

 

TheCompany’s financial condition depends significantly on the quality of itsassets. While its has developed and implemented underwriting policies andprocedures to guide management in the making of loans, compliance with thesepolicies and procedures in making loans does not guarantee repayment of theloans. If the level of non-performing assets rises, the results of operationsand financial condition will be affected. A borrower’s ability to pay its loanin accordance with its terms can be adversely affected by a number of factors,such as a decrease in the borrower’s revenues and cash flows due to adversechanges in economic conditions or a decline in the demand for the borrower’sproducts and/or services.

 

**Allowances for credit losses may beinadequate.**

 

Allowancesfor credit losses are established against each segment of the loan portfolio. AtMarch 31, 2006, the allowance for credit losses equaled 1.29% of loansreceivable and 1520% of nonperforming loans. Although management believes that ithas established adequate allowances for credit losses as of March 31, 2006,the credit quality of the Company’s assets is affected by many factors beyond itscontrol, including local and national economic conditions, and the possibleexistence of facts which are not currently known which adversely affect thelikelihood of repayment of various loans in the loan portfolio and realizationof the collateral upon a default. Accordingly, there is no assurance that theCompany will not sustain loan losses materially in excess of the allowance forcredit losses. In addition, the Office of the Comptroller of the Currency, asan integral part of its examination process, periodically reviews theallowance for credit losses and could require additional provisions for creditlosses. Material future additions to the allowance for credit losses may alsobe necessary due to increases in the size and changes in the composition of theloan portfolio. Increases in the provisions for credit losses would adverselyaffect the Company’s results of operations.

 

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**Economicconditions may worsen.**

 

TheCompany’s business is strongly influenced by economic conditions in its marketarea (principally, the greater Los Angeles metropolitan area) as well asregional and national economic conditions and in its niche markets, includingthe entertainment industry in Southern California. Should the economiccondition in these areas worsen, the financial condition of its borrowers couldweaken, which could lead to higher levels of loan defaults or a decline in thevalue of collateral for its loans. In addition, an unfavorable economy couldreduce the demand for its loans and other products and services.

 

**Because a significant amount of the loans are made toborrowers in Southern California, the Company’s operations could suffer as aresult of local recession or natural disasters in California.**

 

At March 31,2006, a large majority of the loans outstanding were collateralized by realproperties located in California. Because of this concentration in Southern California,the Company’s financial position and results of operations have been and areexpected to continue to be influenced by general trends in the Californiaeconomy and its real estate market. Real estate market declines may adverselyaffect the values of the properties collateralizing loans. If the principalbalances of the loans, together with any primary financing on the mortgagedproperties, equal or exceed the value of the mortgaged properties, the Companycould incur higher losses on sales of properties collateralizing foreclosedloans. In addition, California historically has been vulnerable to certainnatural disaster risks, such as earthquakes and erosion-caused mudslides, whichare not typically covered by the standard hazard insurance policies maintainedby borrowers. Uninsured disasters may adversely impact the ability torecover losses on properties affected by such disasters and adversely impact theCompany’s results of operations.

 

**The Company’s business is very competitive.**

 

Thereis intense competition in Southern California and elsewhere in the UnitedStates for banking customers. The Company experiences competition for depositsfrom many sources, including credit unions, insurance companies and moneymarket and other mutual funds, as well as other commercial banks and savingsinstitutions. The Company competes for loans and deposits primarily with othercommercial banks, mortgage companies, commercial finance companies and savingsinstitutions. In recent years out-of-state financial institutions have enteredthe California market, which has also increased competition. Many of thecompetitors have greater financial strength, marketing capability and namerecognition, and operate on a statewide or nationwide basis. In addition,recent developments in technology and mass marketing have permitted largercompanies to market loans more aggressively to small business customers. Suchadvantages may give the competitors opportunities to realize greaterefficiencies and economies of scale than the Company can. There is no assurancethat the Company will be able to compete effectively against its competition.

 

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**The Company’s 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. Statutesand regulations affecting the Company may be changed at any time, and theinterpretation of these statutes and regulations by examining authorities also may change.There is no assurance that future changes in applicable statutes andregulations or in their interpretation will not adversely affect the Company’sbusiness.

 

**Goodwillis evaluated annually and any impairment must be recorded as a charge toearnings**.

 

Statementof Financial Accounting Standards No. 142 “Goodwill and Other IntangibleAssets” (“SFAS No. 142”), among other provisions, prescribes that goodwilland intangible assets that have indefinite useful lives will not be amortizedbut rather tested annually, or more frequently upon the occurrence of certainevents, for impairment. SFAS No. 142 provides specific guidance for thetesting of goodwill for impairment, which may require re-measurement ofthe fair value of the reporting unit. Impairment losses are to be reported as acharge to current period earnings.

 

The Company has goodwill of $3.2 million in connectionwith the South Bay acquisition in December 2001. During the fourth quarterof 2005, the required impairment tests of goodwill were completed. The testsdetermined that goodwill was not considered impaired. No assurance can be giventhat goodwill will not become impaired in the future.

 

**TheCompany annually evaluates whether the deferred tax asset will be realized andmust establish a valuation allowance if necessary to reduce it to itsrealizable value.**

 

On a periodic basis, atleast annually, an analysis is performed to determine if it is more likely thannot that some or all of the gross deferred tax asset will not be realized. Factorsused in the analysis that are reflective of the future realization of adeferred tax asset are:

 

•                  Future earnings are likely;

 

•                  Expected future taxable incomearising from the reversal of temporary differences adequate to realize the taxasset

 

A valuation allowance may beestablished to reduce the deferred tax asset to its realizable value. Thedetermination of whether a valuation allowance is necessary involvesconsidering the positive and negative factors related to whether the deferredtax asset is more likely than not to be realized. Any adjustment required tothe valuation allowance is coupled with a related entry to income tax expense. Acharge to earnings will be made in the event that a valuation allowance to thedeferred tax asset is necessary. No such valuation allowance existed at March 31,2006.

 

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CAUTIONARY NOTE REGARDING FORWARD-LOOKINGSTATEMENTS

 

This report contains forward-looking statementsabout the Company. Forward-looking statements consist of description of plansor objectives for future operations, products or services, forecasts ofrevenues, earnings or other measures of economic performance and assumptionsunderlying or relating to any of the foregoing. Because forward-lookingstatements discuss future events or conditions and not historical facts, theyoften include words such as “anticipate,” “believe,” “estimate,” “expect,” “intend,”“plan,” “project,” “target,” “can,” “could,” “may,” “should” or similarexpressions. Do not rely unduly on forward-looking statements. They give theCompany’s expectations about the future and are not guarantees or predictionsof futures events, conditions or results. Forward-looking statements speak onlyas of the date they are made, and the Company does not undertake to update themto reflect changes that occur after that date.

 

Many factors, most beyond the Company’s control,could cause actual results to differ significantly from the Company’sexpectations   These include, among otherthings, changes in interest rates which reduce interest margins, impact fundingsources or diminish loan demand; increased competitive pressures; adversechanges in national and local economic conditions, and in real estate marketsin California; changes in fiscal policy, monetary policy; legislative orregulatory environments, requirements or changes which adversely affect theCompany; and declines in the credit quality of the Company’s loan portfolio. See“Factors Which May Affect Future Operating Results.”

 

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

*** ***

The Company maintains disclosure controls andprocedures (as defined in Exchange Act Rule 13a-15(e)) that are designedto assure that information required to be disclosed in its Exchange Act reportsis recorded, processed, summarized and reported within the time periodsspecified in the Securities and Exchange Commission’s rules and forms, andthat such information is accumulated and communicated to management, includingthe Chief Executive Officer and Chief Financial Officer, as appropriate, toallow timely decisions regarding required disclosures.

 

In designing and evaluating the disclosure controlsand procedures, management recognizes that any controls and procedures, nomatter how well designed and operated, can provide reasonable assurance only ofachieving the desired control objectives, and management necessarily isrequired to apply its judgment in weighting the costs and benefits of possiblenew or 

 

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different controls and procedures. Limitations areinherent in all control sysytems, so no evaluation of controls can provideabsolute assurance that all control issues and any fraud within the companyhave been detected.

 

As required by Exchange Act Rule 13a-15(b), as ofthe end of the period covered by this report the Company, under  the supervision and with the participation ofour Chief Executive Officer and Chief Financial Officer, evaluated theeffectiveness of the Company’s disclosure controls and procedures. Based onthis evaluation, our Chief Executive Officer and Chief financial Officerconcluded that the Company’s disclosure controls and procedures were effectiveas of that date.

 

There was no change in the Company’s internal controlover financial reporting during the Company’s most recently completed fiscalquarter that has materially affected, or is reasonably likely to materiallyaffect, the Company’s internal control over financial reporting.

 

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**PART II—OTHER INFORMATION**

 

***Item 1.***          LEGALPROCEEDINGS

*** ***

None.

 

***Item 2.******         ******UNREGISTERED SALES OF EQUITYSECURITIES AND USE OF PROCEEDS***

 

None.

 

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

*** ***

None.

 

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

*** ***

None.

 

***Item 5.******         ******OTHER INFORMATION***

 

None.

 

***Item 6.******         ******EXHIBITS***

 

31.1 Certification of Scott A.Montgomery on disclosure controls

31.2 Certification of David R.Brown on disclosure controls

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

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

 

 

**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 

 
|   | **NATIONAL MERCANTILE BANCORP**                        |   |
|--------|--------------------------------------------------------|--------|
|   | (Registrant)                                           |
|   |                                                   |
| DATE:  | May 19, 2006                                      |   | /s/   SCOTT A. MONTGOMERY |   |
|   | **Scott A. Montgomery**                                |
|   | Chief Executive Officer                                |
|   |                                                   |
| DATE:  | May 19, 2006                                      |   | /s/   DAVID R. BROWN |   |
|   | **David R. Brown**                                     |
|   | Principal Financial and Principal Accounting   Officer |
|        |                                                        |        |  |  |  |

 

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