**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**Form 10-QSB**

 

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

**for thequarterly period ended  March 31, 2005**

 

o  **Transition report under section 13 or 15(d) of the Securities ExchangeAct of 1934**

**for thetransition period from        to       .**

 

**Commission File Number 0-15982**

 

**NATIONAL MERCANTILE BANCORP**

(Exact name of smallbusiness issuer in its charter)

 

| **California**                                                   | ** ** | **95-3819685**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction  of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |

 

| **1880  Century Park East  Los Angeles, California** | ** ** | **90067**  |
|------------------------------------------------------|------------|------------|
| (Address to principal  executive offices)            |       | (Zip Code) |

 

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

 

                Check whether theissuer:  (1) filed all reports requiredto be filed by Section 13 or 15(d) of the Exchange Act of 1934 during the past12 months (or for such shorter period that the registrant was required to file suchreports), and (2) has been subject to such filing requirements for the past 90days.     ýYes   o   No

 

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

 

Check whether the registrant filed all documents and reports requiredto be filed by Section 12, 13 or 15(d) of the Exchange Act  after the distribution of securities under aplan confirmed by a court.   o  Yes       o   No

 

 

**APPLICABLEONLY TO CORPORATE ISSUERS:**

State the number of shares outstanding of each of the issuer’s classesof common equity, as of the latest practicable date:  The number of shares of Common Stock, no parvalue, of the issuer outstanding as of May 11, 2005 was 3,029,784.

 

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

 

 

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PART I — FINANCIAL INFORMATION

 

*Item 1.  FinancialStatements*

 

2

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**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                       | ** ** | **March 31,  2005**          | ** ** | **December 31,  2004** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                       | ** ** | **(Unaudited)**              | ** ** | ** **             | ** ** |
|                                                                                                                                                                                             | ** ** | **(Dollars  in thousands )** | ** ** |
| ASSETS                                                                                                                                                                                           | ** ** | ** **                   | ** ** |
| Cash and due  from banks-demand                                                                                                                                                                  |       | $                            | 16,562     |                   | $          | 14,187 |   |
| Due from  banks-interest bearing                                                                                                                                                                 |       | 2,728                        |       | 2,728                  |       |
| Cash and cash  equivalents                                                                                                                                                                       |       | 19,290                       |       | 16,915                 |       |
| Securities  available-for-sale, at fair value; aggregate amortized cost of $36,200 and  $37,020 at March 31, 2005 and December 31, 2004, respectively                                            |       | 35,841                       |       | 36,954                 |       |
| Securities  held-to-maturity, at amortized cost                                                                                                                                                  |       | 3,284                        |       | 3,507                  |       |
| FRB and other  stock, at cost                                                                                                                                                                    |       | 3,271                        |       | 3,076                  |       |
| Loans receivable                                                                                                                                                                                 |       | 308,500                      |       | 313,847                |       |
| Allowance for  credit losses                                                                                                                                                                     |       | (4,014                       | )          | (3,928                 | )          |
| Net loans  receivable                                                                                                                                                                            |       | 304,486                      |       | 309,919                |       |
|                                                                                                                                                                                             |       |                         |       |                   |       |
| Premises and  equipment, net                                                                                                                                                                     |       | 5,841                        |       | 5,804                  |       |
| Other real  estate owned                                                                                                                                                                         |       | 1,056                        |       | 1,056                  |       |
| Deferred tax  asset                                                                                                                                                                              |       | 5,476                        |       | 5,286                  |       |
| Goodwill                                                                                                                                                                                         |       | 3,225                        |       | 3,225                  |       |
| Core deposit  intangible, net                                                                                                                                                                    |       | 1,574                        |       | 1,630                  |       |
| Accrued interest  receivable and other assets                                                                                                                                                    |       | 3,662                        |       | 3,750                  |       |
| Total assets                                                                                                                                                                                     |       | $                            | 387,006    |                   | $          | 391,122 |   |
|                                                                                                                                                                                             |       |                         |       |                   |       |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY                                                                                                                                                       |       |                         |       |                   |       |
| Deposits:                                                                                                                                                                                        |       |                         |       |                   |       |
| Noninterest-bearing  demand                                                                                                                                                                      |       | $                            | 121,793    |                   | $          | 113,852 |   |
| Interest-bearing  demand                                                                                                                                                                         |       | 30,050                       |       | 34,961                 |       |
| Money market                                                                                                                                                                                     |       | 72,615                       |       | 69,431                 |       |
| Savings                                                                                                                                                                                          |       | 32,762                       |       | 32,199                 |       |
| Time  certificates of deposit:                                                                                                                                                                   |       |                         |       |                   |       |
| $100,000 or more                                                                                                                                                                                 |       | 47,430                       |       | 41,111                 |       |
| Under $100,000                                                                                                                                                                                   |       | 21,125                       |       | 21,988                 |       |
| Total deposits                                                                                                                                                                                   |       | 325,775                      |       | 313,542                |       |
|                                                                                                                                                                                             |       |                         |       |                   |       |
| Other borrowings                                                                                                                                                                                 |       | 9,900                        |       | 25,900                 |       |
| Junior  subordinated deferrable interest debentures                                                                                                                                              |       | 15,464                       |       | 15,464                 |       |
| Accrued interest  payable and other liabilities                                                                                                                                                  |       | 1,066                        |       | 1,734                  |       |
| Total  liabilities                                                                                                                                                                               |       | 352,205                      |       | 356,640                |       |
|                                                                                                                                                                                             |       |                         |       |                   |       |
| Shareholders’  equity:                                                                                                                                                                      |       |                         |       |                   |       |
| Preferred stock,  no par value - authorized 1,000,000 shares:                                                                                                                                    |       |                         |       |                   |       |
| Series A  non-cumulative convertible perpetual preferred stock; authorized 990,000  shares; outstanding 649,625 shares and 666,273 shares at March 31, 2005 and  December 31, 2004, respectively |       | 5,306                        |       | 5,442                  |       |
| Series B  non-cumulative convertible perpetual preferred stock; authorized 1,000  shares; outstanding 1,000 shares at March 31, 2005 and December 31, 2004                                       |       | 1,000                        |       | 1,000                  |       |
| Common stock, no  par value; authorized 10,000,000 shares; outstanding 3,014,834 shares and  2,954,128 shares at March 31, 2005 and December 31, 2004, respectively                              |       | 39,814                       |       | 39,491                 |       |
| Accumulated  deficit                                                                                                                                                                             |       | (10,785                      | )          | (11,726                | )          |
| Accumulated  other comprehensive income (loss)                                                                                                                                                   |       | (534                         | )          | 275                    |       |
| Total  shareholders’ equity                                                                                                                                                                 |       | 34,801                       |       | 34,482                 |       |
| Total liabilities  and shareholders’ equity                                                                                                                                                 |       | $                            | 387,006    |                   | $          | 391,122 |   |

 

See accompanying notes to consolidated financial statements.

 

3

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**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

(Unaudited)

 
| ** **                                                              | ** ** | **For the Three Months Ended  March 31,**          | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                              | ** ** | **2005**                                           | ** ** | **2004** | ** ** |
| ** **                                                              | ** ** | **(Dollars in thousands,  except per share data)** | ** ** |
| ** **                                                              | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| Interest income:                                                        | ** ** | ** **                                         | ** ** | ** ** | ** ** |
| Loans, including  fees                                                  |       | $                                                  | 5,443      |   | $ | 3,785 |   |
| Securities                                                              |       | 368                                                |       | 299 |   |
| Due from banks -  interest bearing                                      |       | 16                                                 |       | 15 |   |
| Federal funds  sold and securities purchased under agreements to resell |       | 10                                                 |       | 42 |   |
| Total interest  income                                                  |       | 5,837                                              |       | 4,141 |   |
| Interest  expense:                                                      |       |                                               |       |   |   |
| Deposits:                                                               |       |                                               |       |   |   |
| Interest-bearing  demand                                                |       | 32                                                 |       | 17 |   |
| Money market and  savings                                               |       | 220                                                |       | 163 |   |
| Time  certificates of deposit:                                          |       |                                               |       |   |   |
| $100,000 or more                                                        |       | 208                                                |       | 83 |   |
| Under $100,000                                                          |       | 142                                                |       | 113 |   |
| Total interest  expense on deposits                                     |       | 602                                                |       | 376 |   |
| Junior  subordinated deferrable interest debentures                     |       | 280                                                |       | 226 |   |
| Other borrowings                                                        |       | 94                                                 |       | 88 |   |
| Total interest  expense                                                 |       | 976                                                |       | 690 |   |
| Net interest  income before provision for credit losses                 |       | 4,861                                              |       | 3,451 |   |
| Provision for  credit losses                                            |       | 89                                                 |       | — |   |
| Net interest  income after provision for credit losses                  |       | 4,772                                              |       | 3,451 |   |
| Other operating  income:                                                |       |                                               |       |   |   |
| Net gain on sale  of securities available-for-sale                      |       | —                                             |       | 19 |   |
| International  services                                                 |       | 10                                                 |       | 14 |   |
| Investment  division                                                    |       | 15                                                 |       | 12 |   |
| Deposit-related  and other customer services                            |       | 297                                                |       | 420 |   |
| Total other  operating income                                           |       | 322                                                |       | 465 |   |
| Other operating  expenses:                                              |       |                                               |       |   |   |
| Salaries and related  benefits                                          |       | 1,838                                              |       | 1,868 |   |
| Net occupancy                                                           |       | 246                                                |       | 291 |   |
| Furniture and  equipment                                                |       | 127                                                |       | 136 |   |
| Printing and  communications                                            |       | 145                                                |       | 133 |   |
| Insurance and  regulatory assessments                                   |       | 108                                                |       | 117 |   |
| Client services                                                         |       | 172                                                |       | 132 |   |
| Computer data  processing                                               |       | 232                                                |       | 261 |   |
| Legal services                                                          |       | 148                                                |       | 103 |   |
| Other  professional services                                            |       | 254                                                |       | 182 |   |
| Amortization of  core deposit intangible                                |       | 56                                                 |       | 56 |   |
| Retirement of  fixed assets and leasehold improvements                  |       | —                                             |       | 43 |   |
| Promotion and  other expenses                                           |       | 160                                                |       | 101 |   |
| Total other  operating expenses                                         |       | 3,486                                              |       | 3,423 |   |
| Income before  income tax provision                                     |       | 1,608                                              |       | 493 |   |
| Income tax  provision                                                   |       | 667                                                |       | 202 |   |
| Net income                                                              |       | $                                                  | 941        |   | $ | 291 |   |
| Earnings per  share:                                                    |       |                                               |       |   |   |
| Basic                                                                   |       | $                                                  | 0.32       |   | $ | 0.10 |   |
| Diluted                                                                 |       | $                                                  | 0.20       |   | $ | 0.06 |   |

 

See accompanying notes to consolidated financial statements.

 

4

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**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(Unaudited)

 
| ** **                                                                                   | ** ** | **For the Three Months Ended March 31,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                   | ** ** | **2005**                                 | ** ** | **2004** | ** ** |
| ** **                                                                                   | ** ** | **(Dollars in thousands)**               | ** ** |
| Cash flows from  operating activities:                                                       |       |                                     |       |   |   |
| Net income                                                                                   |       | $                                        | 941        |   | $ | 291 |   |
| Adjustments to  reconcile net income to net cash provided by (used in) operating activities: |       |                                     |       |   |   |
| Depreciation and  amortization                                                               |       | 103                                      |       | 158 |   |
| Provision for  credit losses                                                                 |       | 89                                       |       | — |   |
| Gain on sale of  securities available for sale                                               |       | —                                   |       | (19 | ) |
| Net amortization  of premium on securities available-for-sale                                |       | 19                                       |       | 25 |   |
| Net amortization  of premium on securities held-to-maturity                                  |       | 8                                        |       | 13 |   |
| Net amortization  of core deposit intangible                                                 |       | 56                                       |       | 56 |   |
| Net amortization  of premium on loans purchased                                              |       | 41                                       |       | 50 |   |
| Decrease in  accrued interest receivable and other assets                                    |       | 467                                      |       | 355 |   |
| Decrease in  accrued interest payable and other liabilities                                  |       | (668                                     | )          | (635 | ) |
| Net cash  provided by operating activities                                                   |       | 1,056                                    |       | 294 |   |
| Cash flows from  investing activities:                                                       |       |                                     |       |   |   |
| Purchase of  securities available-for-sale                                                   |       | (536                                     | )          | (8,607 | ) |
| Proceeds from  sales of securities available-for-sale                                        |       | —                                   |       | 2,019 |   |
| Proceeds from  repayments and maturities of securities available-for-sale                    |       | 1,336                                    |       | 1,309 |   |
| Proceeds from  repayments and maturities of securities held-to-maturity                      |       | 215                                      |       | 210 |   |
| Loan payoffs  (originations) and principal collections, net                                  |       | 4,219                                    |       | (4,882 | ) |
| Purchase of  Federal Reserve Stock and other stocks                                          |       | (195                                     | )          | — |   |
| Purchases of  premises and equipment                                                         |       | (140                                     | )          | (63 | ) |
| Net cash  provided by (used in) investing activities                                         |       | 4,899                                    |       | (10,014 | ) |
| Cash flows from  financing activities:                                                       |       |                                     |       |   |   |
| Net increase in  demand deposits, money market and savings accounts                          |       | 6,777                                    |       | 25,900 |   |
| Net increase  (decrease) in time certificates of deposit                                     |       | 5,456                                    |       | (7,379 | ) |
| Net decrease in  securities sold under agreements to repurchase and federal funds purchased  |       | —                                   |       | (399 | ) |
| Net decrease in  other borrowings                                                            |       | (16,000                                  | )          | — |   |
| Net proceeds  from exercise of stock options                                                 |       | 187                                      |       | 12 |   |
| Net cash  provided by (used in) financing activities                                         |       | (3,580                                   | )          | 18,134 |   |
| Net increase in  cash and cash equivalents                                                   |       | 2,375                                    |       | 8,414 |   |
| Cash and cash  equivalents, January 1                                                        |       | 16,915                                   |       | 39,284 |   |
| Cash and cash  equivalents, March 31                                                         |       | $                                        | 19,290     |   | $ | 47,698 |   |
|                                                                                         |       |                                     |       |   |   |
| Supplemental  disclosures of cash flow information:                                          |       |                                     |       |   |   |
| Cash paid for  interest                                                                      |       | $                                        | 1,205      |   | $ | 802 |   |
| Cash paid for  income taxes                                                                  |       | $                                        | 290        |   | $ | 3 |   |

 

See accompanying notes to consolidated financial statements.

 

5

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**NATIONALMERCANTILE BANCORP AND SUBSIDIARIES**

###### **NOTES TO THEUNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

 

 

 

NOTE1—BASIS OF PRESENTATION AND MANAGEMENT REPRESENTATIONS

 

The unaudited consolidated financial statements include the accounts ofNational Mercantile Bancorp (“National Mercantile” on a parent-only basis, andthe ‘‘Company’’ on a consolidated basis) and its wholly-owned subsidiaries,Mercantile National Bank and South Bay Bank, N.A., (collectively, the “Banks”).  The unaudited consolidated financialstatements reflect all interim adjustments, which are of a normal recurringnature and which, in management’s opinion, are necessary for the fairpresentation of the Company’s consolidated financial position and results ofoperations and cash flows for such interim periods. The results for the threemonths ended March 31, 2005 are not necessarily indicative of the resultsexpected for any subsequent period or for the full year ending December 31,2005.  The unaudited consolidated financialstatements should be read in conjunction with the audited consolidatedfinancial statements included in the Company’s Annual Report on Form 10-KSB forthe year ended December 31, 2004.

 

NOTE2—EARNINGS PER SHARE

 

         Basic earnings per share are computed usingthe weighted average number of common shares outstanding during theperiod.  The weighted average number ofcommon shares outstanding used in computing basic earnings per share anddiluted earnings per share was 2,972,923 and 4,651,028, respectively, for thethree months ended March 31, 2005.   Theweighted average number of common shares outstanding used in computing basicearnings per share and diluted earnings per share was 2,810,522 and 4,664,397,respectively, for the three months ended March 31, 2004.

 

6

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

 
| ** **                                    | ** ** | **Earnings  available to  shareholders** | ** ** | **Weighted  Average  Shares** | ** ** | **Per share  amount** | ** ** |
|-----------------------------------------------|------------|------------------------------------------|------------|-------------------------------|------------|-----------------------|------------|
| ** **                                    | ** ** | **(in thousands)**                       | ** ** | ** **                    | ** ** | ** **            | ** ** |
| ** **                                    | ** ** | ** **                               | ** ** | ** **                    | ** ** | ** **            | ** ** |
| *For the  three months ended March 31, 2005:* |       |                                     |       |                          |       |                  |       |
| Basic earnings  per share                     |       | $                                        | 941        |                          | 2,972,923  |                  | $          | 0.32 |   |
|                                          |       |                                     |       |                          |       |                  |       |
| Effect of  diultive securities:               |       |                                     |       |                          |       |                  |       |
| Options                                       |       |                                     |       | 197,015                       |       |                  |       |
| Convertible  preferred stock                  |       |                                     |       | 1,481,090                     |       |                  |       |
| Diluted earnings  per share                   |       | $                                        | 941        |                          | 4,651,028  |                  | $          | 0.20 |   |
|                                          |       |                                     |       |                          |       |                  |       |
| *For the  three months ended March 31, 2004:* |       |                                     |       |                          |       |                  |       |
| Basic earnings  per share                     |       | $                                        | 291        |                          | 2,810,522  |                  | $          | 0.10 |   |
|                                          |       |                                     |       |                          |       |                  |       |
| Effect of  diultive securities:               |       |                                     |       |                          |       |                  |       |
| Options                                       |       |                                     |       | 351,563                       |       |                  |       |
| Convertible  preferred stock                  |       |                                     |       | 1,502,312                     |       |                  |       |
| Diluted earnings  per share                   |       | $                                        | 291        |                          | 4,664,397  |                  | $          | 0.06 |   |

 

 

NOTE3—CASH AND CASH EQUIVALENTS

 

For purposes of reporting cash flows, cash and cash equivalents includecash, due from banks-demand, due from banks-interest-bearing and federal fundssold.

 

 

NOTE4—ALLOWANCE FOR CREDIT LOSSES 

 

Provisions for credit losses charged to operations reflect management’sjudgment of the adequacy of the allowance for credit losses and are determinedthrough periodic analysis of the loan portfolio.  This analysis includes a detailed review ofthe classification 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 and expected future economic conditions (particularlySouthern California).  Managementperforms a periodic risk and credit analysis, the results of which are reportedto the Board of Directors.

 

7

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The following table sets forth information concerning the Company’sallowance for credit losses for the periods indicated.

 

**Analysisof Changes in Allowance for Credit Losses**

 
| ** **                                                            | ** ** | **Three months ended**      | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                            | ** ** | **March 31,  2005**         | ** ** | **March 31,  2004** | ** ** |
| ** **                                                            |       | **(Dollars  in thousands)** |       |
|                                                                  |       |                        |       |   |   |
| Balance,  beginning of period                                         |       | $                           | 3,928      |   | $ | 3,635 |   |
| Loans charged  off:                                                   |       |                        |       |   |   |
| Commercial -  secured and unsecured                                   |       | 6                           |       | 31 |   |
| Real estate  loans:                                                   |       |                        |       |   |   |
| Secured by  commercial real properties                                |       | —                      |       | — |   |
| Secured by one  to four family residential properties                 |       | —                      |       | — |   |
| Secured by  multifamily residential properties                        |       | —                      |       | — |   |
| Total real  estate loans                                              |       | —                      |       | — |   |
| Construction and  land development                                    |       | —                      |       | — |   |
| Consumer  installment, home equity and unsecured loans to individuals |       | —                      |       | 4 |   |
| Total loans  charged-off                                              |       | 6                           |       | 35 |   |
|                                                                  |       |                        |       |   |   |
| Recoveries of  loans previously charged off:                          |       |                        |       |   |   |
| Commercial -  secured and unsecured                                   |       | 2                           |       | 11 |   |
| Real estate  loans:                                                   |       |                        |       |   |   |
| Secured by  commercial real properties                                |       | —                      |       | — |   |
| Secured by one  to four family residential properties                 |       | —                      |       | — |   |
| Secured by  multifamily residential properties                        |       | —                      |       | — |   |
| Total real  estate loans                                              |       | —                      |       | — |   |
| Construction and  land development                                    |       | —                      |       | 6 |   |
| Consumer  installment, home equity and unsecured loans to individuals |       | 1                           |       | 16 |   |
| Total recoveries  of loans previously charged off                     |       | 3                           |       | 33 |   |
| Net charge-offs                                                       |       | 3                           |       | 2 |   |
| Provision for  credit losses                                          |       | 89                          |       | — |   |
| Balance, end of  period                                               |       | $                           | 4,014      |   | $ | 3,633 |   |

 

 

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

 

 

NOTE 5—GOODWILLAND CORE DEPOSIT INTANGIBLE

 

         As of March 31, 2005 and December 31,2004, the Company had goodwill of $3.2 million, and net core depositintangibles of $1.6 million, from its acquisition of South Bay Bank in December2001.  The gross carrying amount of core

 

8

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depositintangibles was $2.3 million at March 31, 2005 and December 31, 2004, andaccumulated amortization was $726,000 and $670,000, respectively, at suchdates.  The core deposit intangibles areestimated to have a life of 10 years and 4 months. Amortization for intangiblesfor 2005 and each of the next four years is estimated to be $223,000 peryear.  In accordance with SFAS No. 142goodwill is not amortized.  The Companyhas no other recorded indefinite-lived intangible assets.  Goodwill and other intangible assets arereviewed and assessed annually for impairment.

 

 

NOTE 6—INCOMETAXES

 

Income tax provisions of $667,000 and $202,000 were recorded for thethree months ended March 31, 2005 and 2004, respectively.

At March 31, 2005, the Company had: (i) federal net operating losscarry forwards (“NOLS”) of approximately $11.3 million, which begin to expirein the year 2009; and (ii) federal alternative minimum tax “AMT” credits of$400,000.  The AMT credits carry forwardindefinitely.

Management believes that it is more likely than not that the deferredtax asset will be realized.  Accordingly,no valuation allowance has been established against the deferred tax asset.

 

 

NOTE 7—BENEFITPLANS

 

         The estimated per share weightedaverage fair value of options granted in the three months ended March 31, 2005and 2004 was $8.60 and $7.28, respectively. The Company applies AccountingPrinciples Board Opinion No. 25 and related interpretations in accounting forits stock incentive plans.  SFAS No. 123,Accounting for Stock-Based Compensation, encourages, but does not require,companies to record compensation cost for stock-based employee compensationplans at fair value.  Accordingly, nocompensation cost has been recognized for the options.  Had compensation cost for the options grantedbeen determined based on the fair value at the grant dates for awardsconsistent with the method of SFAS No. 123, the Company’s net income for thethree months ended March 31, 2005 and 2004 would have decreased to the proforma amounts indicated below:

 
| ** **                                                                                                                            | ** ** | **Three Months Ended March 31,**                   | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                                                                            | ** ** | **2005**                                           | ** ** | **2004** | ** ** |
| ** **                                                                                                                            | ** ** | **(Dollars in thousands,  except per share data)** | ** ** |
| Net Income:                                                                                                                           |       |                                               |       |   |   |
| As reported                                                                                                                           |       | $                                                  | 941        |   | $ | 291 |   |
|                                                                                                                                  |       |                                               |       |   |   |
| Total  stock-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |       | 36                                                 |       | 31 |   |
| Pro forma                                                                                                                             |       | $                                                  | 905        |   | $ | 260 |   |
|                                                                                                                                  |       |                                               |       |   |   |
| Income Per Share  as Reported:                                                                                                        |       |                                               |       |   |   |
| Basic                                                                                                                                 |       | $                                                  | 0.32       |   | $ | 0.10 |   |
| Diluted                                                                                                                               |       | 0.20                                               |       | 0.06 |   |
| Income Per Share  Pro Forma:                                                                                                          |       |                                               |       |   |   |
| Basic                                                                                                                                 |       | $                                                  | 0.31       |   | $ | 0.09 |   |
| Diluted                                                                                                                               |       | 0.19                                               |       | 0.05 |   |

 

9

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         The fair values of options grantedduring the three months ended March 31, 2005 and 2004 were estimated on thedate of grant using the Black-Scholes option-pricing model with the followingweighted-average assumptions used: 2005— no dividend yield, expected volatilityof 43%, risk-free interest rate of 4.50%, and an expected life of 10 years;2004— no dividend yield, expected volatility of 62%, risk-free interest rate of3.85%, and an expected life of 10 years.

The Financial Accounting Standards Board (“FASB”) issued SFAS No.123(R), “Share-Based Payment” in December 2004, which requires entities thatgrant stock options and shares to employees to recognize the fair value ofthose options and shares as compensation cost over the service (vesting) periodin their financial statements.  Forpublic entities that file as small business issuers, the effective date forSFAS No. 123(R) is the first interim or annual reporting period that begins afterDecember 15, 2005.

 

 

NOTE 8—COMPREHENSIVEINCOME (LOSS)

 

         Comprehensive income (loss) is thechange in equity during a period from transactions and other events andcircumstances from nonowner sources.  Theaccumulated balance of other comprehensive income (loss) is required to bedisplayed separately from retained earnings in the consolidated balancesheet.  Total comprehensive income (loss)was as follows:

 
| ** **                                                                          | ** ** | **Three months ended March 31,** | ** ** |
|-------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                          | ** ** | **2005**                         | ** ** | **2004** | ** ** |
| ** **                                                                          | ** ** | **(Dollars in thousands)**       | ** ** |
| ** **                                                                          | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Net income  (loss)                                                                  |       | $                                | 941        |   | $ | 291 |   |
|                                                                                |       |                             |       |   |   |
| Other  comprehensive income (loss) before tax, and unrealized losses on securities: |       |                             |       |   |   |
| Unrealized gain  (loss) on interest rate swaps used in cash flow hedges             |       | (1,083                           | )          | — |   |
| Unrealized gain  (loss) on securities available for sale                            |       | (425                             | )          | 31 |   |
| Other comprehensive  income (loss), before tax                                      |       | (1,508                           | )          | 31 |   |
|                                                                                |       |                             |       |   |   |
| Income tax  benefit (expense) related to items of other comprehensive income        |       | 699                              |       | (13 | ) |
| Other  comprehensive income (loss)                                                  |       | (809                             | )          | 18 |   |
| Total  comprehensive income                                                         |       | $                                | 132        |   | $ | 309 |   |

 

10

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NOTE 9—DERIVATIVEFINANCIAL INSTRUMENTS

 

         In January 2003, National Mercantileentered into an interest rate swap agreement pursuant to which it exchanged afixed rate payment obligation of 10.25% on a notional principal amount of $15.0million for a floating rate interest based on the six-month London InterBankOffered Rate plus 458 basis points for a 29-year period ending July 25,2031.  The interest rate swap agreementresults in National Mercantile paying or receiving the difference between thefixed and floating rates at specified intervals calculated on the notionalamounts.  The differential paid orreceived on the interest rate swap is recognized as an adjustment to interestexpense.  At March 31, 2005, National Mercantilewas paying an interest rate of 7.50% under the terms of the swap.  The counter party to the swap has the optionto call the swap under a declining premium schedule beginning July 2006.  The Company is hedging against a decline inrates in its portfolio of adjustable rate loans receivable.

         The interest rate swap reduces the costof the 10.25% fixed-rate Junior Subordinated Debentures in a low interest rateenvironment.  The Company does notutilize derivatives for speculative purposes. This swap transaction is designated as a fair value hedge.  Accordingly, the ineffective portion of thechange in the fair value of the swap transaction is recorded each period incurrent operations.  The terms of theswap are symmetrical with the terms of the Junior Subordinated Debentures,including the payment deferral terms, and considered highly effective inoffsetting changes in fair value of the Junior Subordinated Debentures.  A $128,000 decrease in the fair value of theswap was recorded in income for the three-month

 

11

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period ended March31, 2005 with an offsetting charge to earnings to reflect a similar decrease inthe fair value of the Junior Subordinated Debentures.   No ineffectiveness was recorded to currentearnings related to the interest rate swap.

         The terms of the swap require NationalMercantile to provide collateral to support its contract obligations and variesbased upon the swap contract value.  AtMarch 31, 2005, $1.0 million in securities were pledged as collateral.

         On July 1, 2004, the Banks entered intointerest rate swap agreements in which they exchanged an adjustable rateinterest based on the prime rate lending index for a fixed rate payment of6.925% on an aggregate notional principal amount beginning at $50.0 million fora 4-year period, declining to $30.0 million for the fifth year and $10.0million for the sixth year with a final maturity of June 30, 2010.  The interest rate swap agreement results inthe Banks paying or receiving the difference between the fixed and floatingrates at monthly intervals calculated on the notional amounts.  The differential paid or received on theinterest rate swap has been recognized as an adjustment to interest income.  At March 31, 2005, the Banks were paying aninterest rate of 5.75% under the terms of the swap.

         These interest rate swaps reduce thecurrent asset sensitivity of the Company’s balance sheet moderating thepotential negative impact on earnings in the event of declining interestrates.  The Company does not utilizederivatives for speculative purposes. These swap transactions have been designated as cash flow hedges.  Accordingly, the change in fair value of theswaps is recorded each period as other comprehensive income and any ineffectiveportion of the change in the fair value is recorded in current operations.  The Company has a large portion of its loanportfolio that adjusts to changes in the prime rate lending index and thereforethe swaps are currently considered highly effective in offsetting changes inthe cash flows of the loan portfolio.

 

 

NOTE 10—CONVERSION OF PREFERRED STOCK

 

                During the three months endedMarch 31, 2005, 16,648 shares of Series A non-cumulative convertible perpetualpreferred stock were converted into33,296 shares of common stock.

 

 

NOTE11—RECLASSIFICATIONS

 

Certain prior year data have been reclassified to conform to thecurrent year presentation.

 

12

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

 

National Mercantile Bancorp (“National Mercantile” on a parent-onlybasis, and the ‘‘Company’’ on a consolidated basis) is the holding company fortwo subsidiary banks, Mercantile National Bank (“Mercantile”) and South BayBank, N.A. (“South Bay”) (collectively, “the Banks”).  National Mercantile’s principal assets arethe capital stock of Mercantile and South Bay.

 

**RESULTS OFOPERATIONS**

 

The Company recorded net income of $941,000, or $0.32 basic earningsper share and $0.20 diluted earnings per share, for the three months endedMarch 31, 2005 compared to net income of $291,000, or $0.10 basic earnings pershare and $0.06 diluted earnings per share, for the same period of 2004.   The increase in net income for the 2005 periodwas primarily due to a $1.4 million increase in net interest income beforeprovision for credit losses resulting from increases in the prime rate lendingindex, interest rate swaps, 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.

Return on average assets during the first quarter of 2005 was 0.96%compared to 0.32% during the first quarter of 2004. Return on average equityduring the first quarter 2005 was 10.80%, compared to 3.63% during the firstquarter of 2004.

 

NET INTERESTINCOME

 

         Net interest income before theprovision for credit losses increased $1.4 million for the three months endedMarch 31, 2005 compared to the same quarter of 2004 due to a $1.7 millionincrease in total interest income.  Loaninterest income increased $1.7 million due to $49.1 million greater averagevolume of loans receivable and a 129 basis point increase in yield, resultingprimarily from increases in the prime rate lending index and interest rateswaps.  On July 1, 2004, the Banksentered into interest rate swap agreements in which they exchanged anadjustable rate interest based on the prime rate lending index for a fixed ratepayment of 6.925% on an aggregate notional principal amount of $50.0 million(see Note 9—Derivative Financial Instruments of the Notes to ConsolidatedFinancial Statements for details of the swap terms).  The interest rate swaps contributed 25 basispoints to the increase in loan yield. During the second half of 2004 and first quarter of 2005, the FederalReserve Bank increased the federal funds rate on seven occasions totaling 175basis points, after a prolonged period of accommodative monetary policy, inresponse to signs of stronger expansion of the economy.  Approximately 73% of our

 

13

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$308.5 millionloans receivable have adjustable interest rates; accordingly, rising interestrates positively affects interest income partially offset by greater paymentson our $50 million of interest rate swaps.

         Interest income from securitiesavailable-for-sale increased $69,000 during the first quarter 2005 compared tothe first quarter 2004 due to a 23 basis point increase in yield and a $7.0million increase in average volume.  Theincrease in the yield on securities available-for-sale was due to higher yieldson the newly purchased securities.  Thegrowth in securities was a result of the redeployment of lower yielding federalfunds sold, which averaged $16.8 million less than during the 2004 period.

         Overall, interest-earning assets were$42.2 million greater during the first quarter 2005 than first quarter 2004 andthe higher yields and favorable change in composition to higher-yielding assetsresulted in a 133 basis point increase in weighted average yield oninterest-earning assets.

         Interest expense increased $286,000 forthe three months ended March 31, 2005 compared to the same period in 2004, dueto a $34.8 million increase in average interest-bearing liabilities and a 30basis points increase in cost of funds.  Average interest-bearing deposits were $27.4 million greater than thefirst quarter 2004.  Interest expense ondeposits increased $226,000 due to a 33 basis point increase in weightedaverage cost and a $27.4 million increase in average interest-bearing deposits.Relatively low costing interest-bearing demand deposits and money market andsavings deposits averaged $2.1 million and $2.6 million greater, respectively,in the 2005 period compared to the 2004 period. The growth in transactional deposits is due to an emphasis on developingbusiness banking.  Time certificates ofdeposit averaged $22.7 million more during the first quarter 2005 than the sameperiod in 2004.  The cost of timecertificates of deposit increased 38 basis points due to higher rates on newcertificates and repricing of matured certificates during the higher interestrate environment.  Rising market rates ofinterest during the latter half of 2004 and first quarter of 2005 resulted inthe cost of interest-bearing demand deposits and money market and savingsdeposits to increase a moderate 18 basis points and 22 basis points,respectively, compared to the first quarter of 2004.  The Company elected to generally holdtransaction account rates stable and fund earning asset growth during 2004 withtime certificates of deposit and relatively inexpensive overnight otherborrowings.  Other borrowings during thefirst quarter 2005 averaged $15.1 million, or $7.6 million greater than thesame period in 2004.  The cost of otherborrowings was 2.52% and 4.72% for the first quarters of 2005 and 2004,respectively, representing a decline of 220 basis points in 2005 due to agreater volume of short-term advances and the maturity of higher-costing longerterm advances.  In a sustained risinginterest rate environment, increases in deposit interest rates will be requiredto prevent net deposit withdrawals. Noninterest-bearing demand deposits were relatively stable, with adecline of $1.8 million in average volume in the first quarter 2005 compared to2004.

 

14

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         The Company altered its liquiditystrategy during 2004, maintaining a significantly lower level of short-termassets, primarily federal funds sold, and relying on overnight otherborrowings, against pledged loans and securities, to fund loan growth anddeposit outflows.  Liquidity wassupplemented with customer and brokered time certificates of deposit.  This type of funding is typically highercosting and exhibits higher interest rate sensitivity.  The relatively high cost of new timecertificates of deposit, however, impacts a relatively small portion of ourfunding sources.

         The net yield on interest earningassets increased 110 basis points from 4.35% during the first quarter in 2004to 5.45% in the first quarter in 2005, while the net interest spread increased103 basis points from 3.86% during the first quarter in 2004 to 4.89% in the firstquarter in 2005.

         The following table presents thecomponents of net interest income for the three months ended March 31, 2005 and2004.

 

**AverageBalance Sheet and**

**Analysisof Net Interest Income**

 
| ** **                                                                                      | ** ** | **Three months ended**     | ** ** |
|-------------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                      | ** ** | **March 31, 2005**         | ** ** | **March 31, 2004** | ** ** |
| ** **                                                                                      | ** ** | **Average  Amount**        | ** ** | **Interest  Income/  Expense** | ** ** | **Weighted  Average  Yield/  Rate** | ** ** | **Average  Amount** | ** ** | **Interest  Income/  Expense** | ** ** | **Weighted  Average  Yield/  Rate** | ** ** |
| ** **                                                                                      | ** ** | **(Dollars in thousands)** | ** ** |
| Assets:                                                                                         |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Federal funds  sold and securities purchased under agreements to resell                         |       | $                          | 1,667      |   | 10 |   | 2.43 | % | $ | 17,436 |   | 42 |   | 0.97 | % |
| Due from  banks-interest bearing                                                                |       | 7,660                      |       | 16 |   | 0.85 | % | 4,697 |   | 15 |   | 1.28 | % |
| Securities  available-for-sale                                                                  |       | 39,909                     |       | 334 |   | 3.35 | % | 32,920 |   | 257 |   | 3.12 | % |
| Securities  held-to-maturity                                                                    |       | 3,415                      |       | 34 |   | 3.98 | % | 4,509 |   | 42 |   | 3.73 | % |
| Loans  receivable(1)(2)                                                                         |       | 308,766                    |       | 5,443 |   | 7.15 | % | 259,664 |   | 3,785 |   | 5.86 | % |
| Total interest  earning assets                                                                  |       | 361,417                    |       | 5,837 |   | 6.55 | % | 319,226 |   | 4,141 |   | 5.22 | % |
|                                                                                            |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest  earning assets:                                                                    |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Cash and due  from banks - demand                                                               |       | 19,135                     |       |   |   |   |   | 22,963 |   |   |   |   |   |
| Other assets                                                                                    |       | 20,569                     |       |   |   |   |   | 21,491 |   |   |   |   |   |
| Allowance for  credit losses and net unrealized gain on sales of securities  available-for-sale |       | (4,066                     | )          |   |   |   |   | (3,527 | ) |   |   |   |   |
| Total assets                                                                                    |       | $                          | 397,055    |   |   |   |   |   | $ | 360,153 |   |   |   |   |   |
|                                                                                            |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Liabilities and  shareholders’ equity:                                                     |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  deposits:                                                                     |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Demand                                                                                          |       | $                          | 32,036     |   | 32 |   | 0.41 | % | $ | 29,927 |   | 17 |   | 0.23 | % |
| Money market and  savings                                                                       |       | 103,132                    |       | 220 |   | 0.87 | % | 100,537 |   | 163 |   | 0.65 | % |
| Time  certificates of deposit:                                                                  |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| $100,000 or more                                                                                |       | 45,433                     |       | 208 |   | 1.86 | % | 24,141 |   | 83 |   | 1.38 | % |
| Under $100,000                                                                                  |       | 27,767                     |       | 142 |   | 2.07 | % | 26,373 |   | 113 |   | 1.72 | % |
| Total time  certificates of deposit                                                             |       | 73,200                     |       | 350 |   | 1.94 | % | 50,514 |   | 196 |   | 1.56 | % |
| Total  interest-bearing deposits                                                                |       | 208,368                    |       | 602 |   | 1.17 | % | 180,978 |   | 376 |   | 0.84 | % |
| Other borrowings                                                                                |       | 15,139                     |       | 94 |   | 2.52 | % | 7,500 |   | 88 |   | 4.72 | % |
| Junior  subordinated debentures                                                                 |       | 15,464                     |       | 280 |   | 7.34 | % | 15,464 |   | 226 |   | 5.88 | % |
| Federal funds  purchased and securities sold under agreements to repurchase                     |       | —                     |       | — |   | 0.00 | % | 232 |   | — |   | 1.55 | % |
| Total  interest-bearing liabilities                                                             |       | 238,971                    |       | 976 |   | 1.66 | % | 204,174 |   | 690 |   | 1.36 | % |
|                                                                                            |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  liabilities:                                                               |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  demand deposits                                                            |       | 121,408                    |       |   |   |   |   | 123,195 |   |   |   |   |   |
| Other  liabilities                                                                              |       | 1,349                      |       |   |   |   |   | 612 |   |   |   |   |   |
| Shareholders’  equity                                                                      |       | 35,327                     |       |   |   |   |   | 32,172 |   |   |   |   |   |
| Total  liabilities and shareholders’ equity                                                |       | $                          | 397,055    |   |   |   |   |   | $ | 360,153 |   |   |   |   |   |
|                                                                                            |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Net interest  income (spread)                                                                   |       |                       |       | $ | 4,861 |   | 4.89 | % |   |   | $ | 3,451 |   | 3.86 | % |
|                                                                                            |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Net yield on  earning assets(2)                                                                 |       |                       |       |   |   | 5.45 | % |   |   |   |   | 4.35 | % |
|                                                                                                 |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          The average balance of nonperforming loans has beenincluded in loans receivable.

(2)          Yields and amounts earned on loans receivable includeloan fees of $423,000 and $293,000 for the three months ended March 31, 2005and 2004, respectively.

 

15

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

 

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

**AverageVolume and Average Rate(1)**

 
| ** **                                                             | ** ** | **Three months ended March 31,  2005 vs 2004** | ** ** |
|------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                             | ** ** | ** **                                     | ** ** | ** ** | ** ** | **Net  Increase  (Decrease)** | ** ** |
| **Increase (decrease) due to:**                                        |
| **Volume**                                                             | ** ** | **Rate**                                       |
| ** **                                                             | ** ** | **(Dollars in thousands)**                     | ** ** |
| Interest Income:                                                       |       |                                           |       |   |   |   |   |
| Federal funds  sold and securities purchased under agreement to resell |       | $                                              | (38        | ) | $ | 6 |   | $ | (32 | ) |
| Interest-bearing  deposits with other financial institutions           |       | 9                                              |       | (8 | ) | 1 |   |
| Securities  available-for-sale                                         |       | 55                                             |       | 22 |   | 77 |   |
| Securities  held-to-maturity                                           |       | (10                                            | )          | 2 |   | (8 | ) |
| Loans receivable(2)                                                    |       | 696                                            |       | 962 |   | 1,658 |   |
| Total  interest-earning assets                                         |       | 712                                            |       | 984 |   | 1,696 |   |
|                                                                   |       |                                           |       |   |   |   |   |
| Interest  Expense:                                                     |       |                                           |       |   |   |   |   |
| Interest-bearing  deposits:                                            |       |                                           |       |   |   |   |   |
| Demand                                                                 |       | $                                              | 1          |   | $ | 14 |   | $ | 15 |   |
| Money market and  savings                                              |       | 4                                              |       | 53 |   | 57 |   |
| Time  certificates of deposit:                                         |       |                                           |       |   |   |   |   |
| $100,000 or more                                                       |       | 71                                             |       | 53 |   | 125 |   |
| Under $100,000                                                         |       | 6                                              |       | 23 |   | 29 |   |
| Total time  certificates of deposit                                    |       | 77                                             |       | 76 |   | 153 |   |
| Total  interest-bearing deposits                                       |       | 83                                             |       | 143 |   | 226 |   |
| Other borrowings                                                       |       | 88                                             |       | (82 | ) | 6 |   |
| Junior  subordinated debentures                                        |       | —                                         |       | 54 |   | 54 |   |
| Total  interest-bearing liabilities                                    |       | 171                                            |       | 115 |   | 286 |   |
|                                                                   |       |                                           |       |   |   |   |   |
| Net interest  income                                                   |       | $                                              | 541        |   | $ | 869 |   | $ | 1,410 |   |

----

(1)          The change in interest income or interest expense thatis attributable to both changes in average balance, average rate and days inthe quarter has been allocated to the changes due to (i) average balance and(ii) average rate in proportion to the relationship of the absolute amounts ofchanges in each.

(2)          Table does not include interest income that would havebeen earned on nonaccrual loans.

 

16

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PROVISION FORCREDIT LOSSES

 

The Company recorded an $89,000 provision for credit losses for thethree months ended March 31, 2005 compared to no provision for the three monthsended March 31, 2004.  The provision inthe first quarter of 2005 was primarily due to changes in management’s viewrelating to continuing economic uncertainty, increased credit risk in a risinginterest rate environment, particularly in the adjustable rate loans, and therelatively larger size credits in new loan originations. See Note 4 of Notes toConsolidated Financial Statements.

 

OTHER OPERATINGINCOME

 

Other operating income decreased to $322,000 during the first quarterof 2005 from $465,000 during the first quarter of 2004 primarily due to a$123,000 decrease in deposit-related and other customer services incomeresulting from changes in deposit fee structures.

 

OTHER OPERATING EXPENSES

 

Otheroperating expenses increased to $3.5 million for the three months ended March31, 2005 compared to $3.4 million for the same period of 2004. Variances withinoperating expenses were: (i) salaries and related benefits expense decreased$30,000 or 1.6% due to a reduction in staffing levels during 2004 related tothe consolidation of client services partially offset by the addition ofbusiness development staff and increased commission expense; (ii) net occupancyexpense decreased $45,000 or 15.5% due to a reduction in rent from therelocation of the Company’s headquarters office and banking office in CenturyCity; (iii) client services expense increased $40,000 or 30.3% due to greaterservice allowances for compensating deposit balances; (iv) legal servicesexpense increased $45,000 or 43.7% primarily due to continued activity on thesettlement of a dispute over collateral securing a borrower’s loan;  (v) other professional services expenseincreased $72,000 or 39.6% due to a productivity consultant engagement andincreased costs for audit services; (vi) promotional and other expensesincreased $59,000 or 58.4% due to additional accruals for a contingent loss onthe collateral dispute; (vii) computer data processing expense decreased$29,000 from first quarter 2004 and (viii) $43,000 for the retirement of fixedassets and leasehold improvements related to the headquarter’s relocation inthe 2004 period.

 

17

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***BALANCE SHEET ANALYSIS***

 

INVESTMENTSECURITIES

 

The followingcomparative period-end table sets forth certain information concerning theestimated fair values andunrealized gains and losses of securities available-for-sale and securitiesheld-to-maturity.

 

**Estimated Fair Values of and Unrealized**

**Gains and Losses on Securities**

 
| ** **                                                                | ** ** | **March 31, 2005**         | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                | ** ** | **Total  amortized  cost** | ** ** | **Gross  unrealized  gains** | ** ** | **Gross  unrealized  loss** | ** ** | **Estimated  fair  value** | ** ** |
| ** **                                                                | ** ** | **(Dollars in thousands)** | ** ** |
| **Available-for-Sale:**                                                   |       |                       |       |   |   |   |   |   |   |
| U.S. Treasury  securities                                                 |       | $                          | 697        |   | $ | — |   | $ | 4 |   | $ | 693 |   |
| GNMA-issued/guaranteed  mortgage pass through certificates                |       | 136                        |       | 5 |   | — |   | 141 |   |
| Other U.S.  Government and federal agency securities                      |       | 22,963                     |       | — |   | 262 |   | 22,701 |   |
| FHLMC/FNMA-issued  mortgage pass through certificates                     |       | 9,695                      |       | 58 |   | 98 |   | 9,655 |   |
| CMO’s and  REMIC’s issued by U.S. government-sponsored agencies |       | 34                         |       | — |   | — |   | 34 |   |
| Privately issued  corporate bonds, CMO and REMIC securities               |       | 2,675                      |       | 1 |   | 59 |   | 2,617 |   |
|                                                                      |       | $                          | 36,200     |   | $ | 64 |   | $ | 423 |   | $ | 35,841 |   |
|                                                                      |       |                       |       |   |   |   |   |   |   |
| FRB and other  equity stocks                                              |       | $                          | 3,271      |   | — |   | — |   | $ | 3,271 |   |

 
| ** **                                            | ** ** | **March 31, 2005**         | ** ** |
|-------------------------------------------------------|------------|----------------------------|------------|
| ** **                                            | ** ** | **Total  amortized  cost** | ** ** | **Gross  unrealized  gains** | ** ** | **Gross  unrealized  loss** | ** ** | **Estimated  fair  value** | ** ** |
| ** **                                            | ** ** | **(Dollars in thousands)** | ** ** |
| **Held-to-Maturity:**                                 |       |                       |       |   |   |   |   |   |   |
| FHLMC/FNMA-issued  mortgage pass through certificates |       | $                          | 3,284      |   | $ | — |   | $ | 34 |   | $ | 3,250 |   |
|                                                  |       | $                          | 3,284      |   | $ | — |   | $ | 34 |   | $ | 3,250 |   |

 
| ** **                                                                | ** ** | **December 31, 2004**      | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                | ** ** | **Total  amortized  cost** | ** ** | **Gross  unrealized  gains** | ** ** | **Gross  unrealized  loss** | ** ** | **Estimated  fair  value** | ** ** |
| ** **                                                                | ** ** | **(Dollars in thousands)** | ** ** |
| **Available-For-Sale:**                                                   |       |                       |       |   |   |   |   |   |   |
| U.S. Treasury  securities                                                 |       | $                          | 696        |   | $ | — |   | $ | 2 |   | $ | 694 |   |
| GNMA-issued/guaranteed  mortgage pass through certificates                |       | 164                        |       | 7 |   | — |   | 171 |   |
| Other U.S.  government and federal agency securities                      |       | 23,958                     |       | — |   | 128 |   | 23,830 |   |
| FHLMC/FNMA-issued  mortgage pass through certificates                     |       | 9,288                      |       | 76 |   | 1 |   | 9,363 |   |
| CMO’s and  REMIC’s issued by U.S. government-sponsored agencies |       | 38                         |       | — |   | — |   | 38 |   |
| Privately issued  corporate bonds, CMO and REMIC securities               |       | 2,876                      |       | 1 |   | 19 |   | 2,858 |   |
|                                                                      |       | $                          | 37,020     |   | $ | 84 |   | $ | 150 |   | $ | 36,954 |   |
|                                                                      |       |                       |       |   |   |   |   |   |   |
| FRB and other  equity stocks                                              |       | $                          | 3,076      |   | — |   | — |   | $ | 3,076 |   |

 
| ** **                                            | ** ** | **December 31, 2004**      | ** ** |
|-------------------------------------------------------|------------|----------------------------|------------|
| ** **                                            | ** ** | **Total  amortized  cost** | ** ** | **Gross  unrealized  gains** | ** ** | **Gross  unrealized  loss** | ** ** | **Estimated  fair  value** | ** ** |
| ** **                                            | ** ** | **(Dollars in thousands)** | ** ** |
| **Held-to-Maturity:**                                 |       |                       |       |   |   |   |   |   |   |
| FHLMC/FNMA-issued  mortgage pass through certificates |       | $                          | 3,507      |   | $ | 40 |   | $ | — |   | $ | 3,547 |   |
|                                                  |       | $                          | 3,507      |   | $ | 40 |   | $ | — |   | $ | 3,547 |   |

 

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As of March 31, 2005, the Company did not hold securities ofany issuer, other than U.S. government agencies and corporations, the aggregatebook value of which exceeded 10% of the Company’s shareholders’ equity.  At March 31, 2005 and December 31, 2004,there were no securities deemed by management to be other-than-temporarilyimpaired.

 

 

LOANPORTFOLIO

 

The following comparative period-end table sets forth certaininformation concerning the composition of the loan portfolio.

 

**LoanPortfolio Composition**

 
| ** **                                                            | ** ** | **March 31,  2005**        | ** ** | **December 31,  2004** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------|------------|------------------------|------------|
| ** **                                                            | ** ** | **Amount**                 | ** ** | **Percent**            | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **                                                            | ** ** | **(Dollars in thousands)** | ** ** |
| Commercial loans  - secured and unsecured                             |       | $                          | 99,176     |                   | 32         | % | $ | 98,429 |   | 31 | % |
| Real estate  loans:                                                   |       |                       |       |                   |       |   |   |   |   |
| Secured by  commercial real properties                                |       | 129,695                    |       | 42                     | %          | 135,944 |   | 43 | % |
| Secured by one  to four family residential properties                 |       | 9,527                      |       | 3                      | %          | 9,405 |   | 3 | % |
| Secured by  multifamily residential properties                        |       | 17,594                     |       | 6                      | %          | 18,330 |   | 6 | % |
| Total real  estate loans                                              |       | 156,816                    |       | 51                     | %          | 163,679 |   | 52 | % |
| Construction and  land development                                    |       | 50,019                     |       | 16                     | %          | 50,289 |   | 16 | % |
| Consumer  installment, home equity and unsecured loans to individuals |       | 3,545                      |       | 1                      | %          | 2,516 |   | 1 | % |
| Total loans  outstanding                                              |       | 309,556                    |       | 100                    | %          | 314,913 |   | 100 | % |
|                                                                  |       |                       |       |                   |       |   |   |   |   |
| Deferred net  loan origination fees                                   |       | (1,056                     | )          |                   |       | (1,066 | ) |   |   |
| Loans  receivable, net                                                |       | $                          | 308,500    |                   |       |   | $ | 313,847 |   |   |   |

 

 

Total loans outstanding decreased by $5.3 million to $308.5 million atMarch 31, 2005 compared to $313.8 million at December 31, 2004 due primarily tomore rapid payoffs than funding of commercial real estate loans.  Real estate loans secured by commercial realproperties decreased $6.2 million from $135.9 million at December 31, 2004 to$129.7 million at March 31, 2005.  Wehave experienced significant price competition, particularly for fixed rates oncommercial real estate loans.

 

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NONPERFORMINGASSETS

 

The following comparativeperiod-end table sets forth certain information concerning nonperformingassets.

 

**NonperformingAssets**

 
| ** **                                                                                                                  | ** ** | **March 31,  2005**        | ** ** | **December 31,  2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|------------------------|------------|
| ** **                                                                                                                  | ** ** | **(Dollars in thousands)** |
| Nonaccrual loans                                                                                                            |       | $                          | —     |                   | $          | 18 |   |
| Troubled debt  restructurings                                                                                               |       | —                     |       | —                 |       |
| Loans contractually  past due ninety or more days with respect to either principal or interest and  still accruing interest |       | 1,804                      |       | 1,804                  |       |
| Nonperforming  loans                                                                                                        |       | 1,804                      |       | 1,822                  |       |
| Other real  estate owned                                                                                                    |       | 1,056                      |       | 1,056                  |       |
| Other  nonperforming assets                                                                                                 |       | —                     |       | —                 |       |
| Total  nonperforming assets                                                                                                 |       | $                          | 2,860      |                   | $          | 2,878 |   |
|                                                                                                                        |       |                       |       |                   |       |
| Allowance for  credit losses as a percent of nonaccrual loans                                                               |       | 0.0                        | %          | 21822.2                | %          |
| Allowance for  credit losses as a percent of nonperforming loans                                                            |       | 222.5                      | %          | 215.6                  | %          |
| Total  nonperforming assets as a percent of loans receivable                                                                |       | 0.9                        | %          | 0.9                    | %          |
| Total  nonperforming assets as a percent of total shareholders’ equity                                                 |       | 8.2                        | %          | 8.3                    | %          |

 

 

The $1.8 million in loans contractually past due ninety days or moreand still accruing at March 31, 2005 and December 31, 2004 is a single loansecured by a commercial real estate property.  The borrower has entered into an agreement to sell the property for $2.4million with the sale scheduled to close in the second quarter.  If the sale closes at that price, the Companywill be repaid the full amount of its loan and all other amounts due.

 

 

ALLOWANCEFOR CREDIT LOSSES

 

Provisions for credit losses charged to operations reflect management’sjudgment of the adequacy of the allowance for credit losses and are determinedthrough periodic analysis of the loan portfolio.  This analysis includes a detailed review ofthe classification and categorization of problem loans and loans to be chargedoff; an assessment of the overall quality and collectibility of the portfolio;and consideration of the loan loss experience, trends in problem loanconcentrations of credit risk, as well as current and expected future economicconditions (particularly Southern California). Management, in conjunction

 

20

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with an outsideadvisory firm, performs a periodic risk and credit analysis, the results ofwhich are reported to the Board of Directors.

Loans charged off during the first quarter of 2005 were $6,000.  This compares to loans charged off of $35,000during the first quarter of 2004. Recoveries of loans previously charged off were $3,000 during the firstquarter of 2005, compared to $33,000 during the first quarter of 2004.  See Note 4 of Notes to Consolidated FinancialStatements.

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

 

 

DEPOSITS

 

Total deposits were $325.8 million and $313.5 million at March 31, 2005and December 31, 2004, respectively. Noninterest-bearing demand deposits increased to $121.8 million at March31, 2005 compared to $113.9 million at December 31, 2004.  Our noninterest-bearing demand deposits experiencesignificant variability and seasonality due to the nature of our depositors’businesses and the cash needs of our business customers for quarterly taxpayments and owner distributions. Noninterest-bearing demand deposits declined significantly at December31, 2004 from the fourth quarter average of $129.0 million; thus the increaseat March 31, 2005 reflected a normalization following this year-endvariability.  Money market deposits andsavings deposits were $72.6 million and $32.8 million, respectively, at March31, 2005 compared to $69.4 million and $32.2 million, respectively, at December31, 2004.  Interest-bearing demanddeposits, which for the most part are limited to individuals, decreased to$30.1 million at March 31, 2005 from $35.0 million at December 31, 2004.  Similar to noninterest-bearing demanddeposits, interest-bearing demand deposits increased significantly at December31, 2004 from the fourth quarter average of $31.7 million, thus the decline atMarch 31, 2005 reflected a normalization following the year-endvariability.  Time certificates ofdeposit (“TCDs”) increased to $68.6 million at March 31, 2005 from $63.1million at December 31, 2004 due to an increase in brokered deposits.  There were $11.5 million in brokered TCDs atMarch 31, 2005 compared to $6.9 million at December 31, 2004.

 

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         During the first quarter of 2005, theCompany supplemented its liquidity with brokered time certificates of depositranging in term from three months to one year. Additionally, although management has priced its retail certificates ofdeposit to encourage runoff during the past several years, in the rising rateenvironment experienced during the first quarter of 2005, it has elected togenerally maintain stable rates on its immediately repriceable base of deposits— interest-bearing demand deposits, and savings and money market deposits — andprice new time certificates of deposit to generate growth.

 

 

OTHER BORROWINGS

 

**        **Other borrowings, consisting of advances from the Federal Home LoanBank, were $9.9 million at March 31, 2005 compared to $25.9 million at December31, 2004.   The decline in otherborrowings reflected repayment at maturity due to the decline in loansreceivable and increase in deposits.

 

 

SHAREHOLDERS’ EQUITY

 

Shareholders’ equity increased from $34.5 million at December 31, 2004to $34.8 million at March 31, 2005 due to the retained earnings for the threemonths ended March 31, 2005 partially offset by the decrease in market value ofinterest rate swaps and securities available-for-sale.

 

 

***CAPITALADEQUACY REQUIREMENTS***

 

         At March 31, 2005, the Company and theBanks were in compliance with all applicable regulatory capital requirementsand the Banks were “well capitalized” under the Prompt Corrective Action rulesof the OCC.  The following table setsforth the regulatory capital standards for well-capitalized institutions, andthe capital ratios for the Company and the Banks, as of March 31, 2005 andDecember 31, 2004.

 

22

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**Regulatory Capital Information**

**of the National MercantileBancorp and Banks**

 
| ** **                        | ** ** | **Minimum  For Capital  Adequacy  Purposes** | ** ** | **Well  Capitalized  Standards** | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|-----------------------------------|------------|----------------------------------------------|------------|----------------------------------|------------|---------------------|------------|------------------------|------------|
| **National  Mercantile Bancorp:** |       |                                         |       |                             |       |                |       |                   |       |
| Tier 1 leverage                   |       | 4.00                                         | %          | N/A                              |       | 10.09               | %          | 9.87                   | %          |
| Tier 1  risk-based capital        |       | 4.00                                         | %          | N/A                              |       | 11.28               | %          | 10.39                  | %          |
| Total risk-based  capital         |       | 8.00                                         | %          | N/A                              |       | 13.41               | %          | 12.42                  | %          |
|                              |       |                                         |       |                             |       |                |       |                   |       |
| **Mercantile  National Bank:**    |       |                                         |       |                             |       |                |       |                   |       |
| Tier 1 leverage                   |       | 4.00                                         | %          | 5.00                             | %          | 9.53                | %          | 8.99                   | %          |
| Tier 1  risk-based capital        |       | 4.00                                         | %          | 6.00                             | %          | 11.39               | %          | 10.44                  | %          |
| Total risk-based  capital         |       | 8.00                                         | %          | 10.00                            | %          | 12.64               | %          | 11.60                  | %          |
|                              |       |                                         |       |                             |       |                |       |                   |       |
| **South  Bay Bank, NA:**          |       |                                         |       |                             |       |                |       |                   |       |
| Tier 1 leverage                   |       | 4.00                                         | %          | 5.00                             | %          | 9.94                | %          | 9.32                   | %          |
| Tier 1  risk-based capital        |       | 4.00                                         | %          | 6.00                             | %          | 10.29               | %          | 9.32                   | %          |
| Total risk-based  capital         |       | 8.00                                         | %          | 10.00                            | %          | 11.35               | %          | 10.29                  | %          |

 

 

***LIQUIDITY***

 

The Company manages its liquidity through a combination of coredeposits, federal funds purchased, repurchase agreements, collateralizedborrowing lines, and a portfolio of securities available for sale.  Liquidity is also provided by maturinginvestment securities and loans.

The Company’s cash and due from banks - demand was$16.6 million on March 31, 2005 compared to $14.2 million on December 31,2004.  Due from banks-interest-bearingwas $2.7 million at March 31, 2005 and December 31, 2004, respectively.  There were no Federal funds sold at March 31,2005 and December 31, 2004.  Mercantilehad $5.0 million and South Bay had $12.0 million in Federal funds lines withcorrespondent banks as of March 31, 2005.

         National Mercantile is a legal entityseparate and distinct from the Banks, and therefore it must provide for its ownliquidity.  National Mercantile’sprincipal sources of funds are proceeds from the sales of securities anddividends or capital distributions from the Banks.  In addition to its own operating expenses,National Mercantile is responsible for the payment of the interest on theoutstanding Junior Subordinated Debentures. The semiannual interest payments on the Junior Subordinated Debentures,under the terms of the indenture, are deferrable at National Mercantile’soption, for a period up to ten consecutive semiannual payments, but in anyevent not beyond June 25, 2031.  National Mercantile has not deferred any interest payments.

         National Mercantile’s cash and due frombanks was $142,000 on March 31, 2005 compared to $174,000 at December 31,2004.   Due from banks-interest bearingwas $1.0 million at March 31, 2005 compared to $1.7 million at December 31,2004.

 

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Dividends and capital distributions from the Banksconstitute the principal ongoing source of cash to National Mercantile.  The Banks are subject to various statutoryand regulatory restrictions on their ability to pay dividends and capitaldistributions to National Mercantile.

OCC approval is required for a national bank to pay adividend if the total of all dividends declared in any calendar year exceedsthe total of the bank’s net profits (as defined) for that year combined withits retained net profits for the preceding two calendar years, less anyrequired transfer to surplus or a fund for the retirement of any preferredstock.  A national bank may not pay anydividend that exceeds its retained net earnings, as defined by the OCC.  The OCC and the Federal Reserve have alsoissued banking circulars emphasizing that the level of cash dividends shouldbear a direct correlation to the level of a national bank’s current andexpected earnings stream, the bank’s need to maintain an adequate capital baseand other factors.

National banks that are not in compliance withregulatory capital requirements generally are not permitted to paydividends.  The OCC also can prohibit anational bank from engaging in an unsafe or unsound practice in itsbusiness.  Depending on the bank’sfinancial condition, payment of dividends could be deemed to constitute anunsafe or unsound practice.     Exceptunder certain circumstances, and with prior regulatory approval, a bank may notpay a dividend if, after so doing, it would be undercapitalized.  A bank’s ability to pay dividends in thefuture is, and could be, further influenced by regulatory policies oragreements and by capital guidelines.

Mercantile has a substantial accumulated deficit anddoes not anticipate having positive cumulative retained earnings for theforeseeable future.  South Bay hadcumulative retained earnings of  $2.2million as of March 31, 2005.  Mercantileand South Bay may from time to time be permitted to make capital distributionsto National Mercantile with the consent of the OCC.  It is likely that such consent could not beobtained unless the distributing bank were to remain “well capitalized”following such distribution.

 

 

***ASSET LIABILITY MANAGEMENT***

 

The following table shows that the Company’s cumulative one-yearinterest rate sensitivity gap indicated an asset sensitive position of $59.2million at March 31, 2005, a $3.5 million increase from an asset sensitiveposition of $55.8 million at December 31, 2004. This change resulted primarily from an increase in securities repricingafter three months but within one year and a decrease in other borrowingspartially offset by a decrease in adjustable loans receivable and an increasein time certificates of deposit.

 

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Interest rate sensitivity is managed by matching the repricingopportunities on the Company’s earning assets to those on the fundingliabilities.  Various strategies are usedto manage the repricing characteristics of assets and liabilities to ensure thatexposure to interest rate fluctuations is limited within guidelines ofacceptable levels of risk-taking. Hedging strategies, including the terms and pricing of loans anddeposits, the use of derivative financial instruments and managing thedeployment of securities are used to reduce mismatches in interest raterepricing opportunities of portfolio assets and their funding sources.  Interest rate risk is measured usingfinancial modeling techniques, including stress tests, to measure the impact ofchanges in interest rates on future earnings. These static measurements do not reflect the results of any projectedactivity and are best used as early indicators of potential interest rateexposures.

 The Company’s asset sensitiveposition during a period of slowly declining interest rates is not expected tohave a significant negative impact on net interest income since rates paid onthe Company’s large base of interest-bearing demand, savings and money marketdeposits historically have not changed proportionately with changes in interestrates.  However, since the Company is inan asset sensitive position, in a period of rapidly declining rates, such asthe environment that was experienced during 2001 and 2002, the rapid declinewill have a negative effect on the Company’s net interest income as changes inthe rates of interest-bearing deposits historically have not changed in similarmagnitude to changes in market interest rates. Additionally, in relatively low and declining interest rateenvironments, the interest rates paid on funding liabilities may begin to reachfloors preventing further downward adjustments while rates on earning assetscontinue to adjust downward.  During thesecond quarter of 2005, the Company purchased $225 million of interest rate floorsat various strike prices and terms to partially mitigate the negative effectsof rapidly declining interest rates on its net interest margin.  Alternatively, a rising interest rateenvironment tends to positively effect 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 on earning assets.

 

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**Rate-Sensitive Assetsand Liabilities**

 

 
| ** **                                                               | ** ** | **March 31, 2005**            | ** ** |
|--------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                               | ** ** | **Maturing or repricing in**  | ** ** |
| ** **                                                               | ** ** | **Less  than  three  months** | ** ** | **After three  months  but within  one year** | ** ** | **After one  year  but within  5 years** | ** ** | **After  5 years** | ** ** | **Total** | ** ** |
| ** **                                                               |       | **(Dollars  in thousands)**   |       |
| Rate-Sensitive  Assets:                                                  |       |                          |       |   |   |   |   |   |   |   |   |
| Federal funds  sold and securities purchased under agreements to resell  |       | $                             | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Securities at  amortized cost                                            |       | 625                           |       | 14,586 |   | 12,779 |   | 11,494 |   | 39,484 |   |
| Due from banks -  interest bearing                                       |       | 2,728                         |       | — |   | — |   | — |   | 2,728 |   |
| FRB and other  stock, at cost                                            |       | —                        |       | — |   | — |   | 3,271 |   | 3,271 |   |
| Loans receivable(1)                                                      |       | 232,069                       |       | 14,189 |   | 45,117 |   | 17,125 |   | 308,500 |   |
| Total  rate-sensitive assets                                             |       | 235,422                       |       | 28,775 |   | 57,896 |   | 31,890 |   | 353,983 |   |
|                                                                     |       |                          |       |   |   |   |   |   |   |   |   |
| Rate-Sensitive  Liabilities:(2)                                          |       |                          |       |   |   |   |   |   |   |   |   |
| Interest bearing  deposits:                                              |       |                          |       |   |   |   |   |   |   |   |   |
| Demand, money  market and savings                                        |       | 135,427                       |       | — |   | — |   | — |   | 135,427 |   |
| Time  certificates of deposit                                            |       | 23,198                        |       | 36,434 |   | 8,884 |   | 39 |   | 68,555 |   |
| Other borrowings                                                         |       | 9,900                         |       | — |   | — |   | — |   | 9,900 |   |
| Total  rate-sensitive liabilities                                        |       | 168,525                       |       | 36,434 |   | 8,884 |   | 39 |   | 213,882 |   |
| Interest  rate-sensitivity gap                                           |       | 66,897                        |       | (7,659 | ) | 49,012 |   | 31,851 |   | 140,101 |   |
| Cumulative  interest rate-sensitivity gap                                |       | $                             | 66,897     |   | $ | 59,238 |   | $ | 108,250 |   | $ | 140,101 |   |   |   |
| Cumulative ratio  of rate sensitive assets to rate-sensitive liabilities |       | 140                           | %          | 129 | % | 151 | % | 166 | % |   |   |
|                                                                          |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          Loans receivable excludes nonaccrual loans.

(2)          Deposits which are subject to immediate withdrawal arepresented as repricing within three months or less. The distribution of othertime deposits is based on scheduled maturities.

 

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| ** **                                                               | ** ** | **December 31, 2004**         | ** ** |
|--------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                               | ** ** | **Maturing or repricing in**  | ** ** |
| ** **                                                               | ** ** | **Less  than  three  months** | ** ** | **After three  months  but within  one year** | ** ** | **After one  year**

**but within  5 years** | ** ** | **After   5 years** | ** ** | **Total** | ** ** |
| ** **                                                               | ** ** | **(Dollars  in thousands)**   | ** ** |
| Rate-Sensitive  Assets:                                                  |       |                          |       |   |   |   |   |   |   |   |   |
| Federal funds  sold and securities purchased under agreements to resell  |       | $                             | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Securities  available-for-sale, at amortized cost                        |       | 500                           |       | $ | 6,696 |   | $ | 15,885 |   | $ | 13,939 |   | $ | 37,020 |   |
| Securities  held-to-maturity                                             |       | —                        |       | — |   | — |   | 3,507 |   | 3,507 |   |
| Due from banks -  interest bearing                                       |       | 2,728                         |       | — |   | — |   |   |   | 2,728 |   |
| FRB and other  stock, at cost                                            |       | —                        |       | — |   | — |   | 3,076 |   | 3,076 |   |
| Loans receivable  (1)                                                    |       | 251,134                       |       | 10,468 |   | 40,991 |   | 11,236 |   | 313,829 |   |
| Total  rate-sensitive assets                                             |       | 254,362                       |       | 17,164 |   | 56,876 |   | 31,758 |   | 360,160 |   |
|                                                                     |       |                          |       |   |   |   |   |   |   |   |   |
| Rate-Sensitive  Liabilities: (2)                                         |       |                          |       |   |   |   |   |   |   |   |   |
| Interest bearing  deposits:                                              |       |                          |       |   |   |   |   |   |   |   |   |
| Demand, money  market and savings                                        |       | 136,591                       |       | — |   | — |   | — |   | 136,591 |   |
| Time  certificates of deposit                                            |       | 26,708                        |       | 26,543 |   | 9,848 |   | — |   | 63,099 |   |
| Other borrowings                                                         |       | 25,900                        |       | — |   | — |   | — |   | 25,900 |   |
| Total  rate-sensitive liabilities                                        |       | 189,199                       |       | 26,543 |   | 9,848 |   | — |   | 225,590 |   |
| Interest  rate-sensitivity gap                                           |       | 65,163                        |       | (9,379 | ) | 47,028 |   | 31,758 |   | 134,570 |   |
| Cumulative  interest rate-sensitivity gap                                |       | $                             | 65,163     |   | $ | 55,784 |   | $ | 102,812 |   | $ | 134,570 |   |   |   |
| Cumulative ratio  of rate sensitive assets to rate-sensitive liabilities |       | 134                           | %          | 126 | % | 146 | % | 160 | % |   |   |

----

(1)          Loans receivable excludes nonaccrual loans.

(2)          Deposits which are subject to immediate withdrawal arepresented as repricing within three months or less. The distribution of othertime deposits is based on scheduled maturities.

 

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# **FACTORS WHICH MAYAFFECT FUTURE OPERATING RESULTS**

 

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

 

**We face risk from changes in interest rates.**

 

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

•                  Ourability to originate loans;

•                  Theability of our borrowers to make payments on their loans;

•                  Thevalue of our interest-earning assets and our ability to realize gains from thesale of these assets;

•                  Theaverage life of our interest-earning assets;

•                  Ourability to generate deposits instead of other available funding alternatives;and

•                  Ourability to access the wholesale funding market.

Interest rates are highly sensitive to many factors,including governmental monetary policies, domestic and international economicand political conditions and other factors beyond our control.

 

**We face risk from possible declines in the qualityof our assets.**

 

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

 

**Our allowances for credit losses maybe inadequate.**

 

We establishallowances for credit losses against each segment of our loan portfolio.  At March 31, 2005, our allowance for creditlosses equaled 1.3% of loans receivable and 222.5% of nonperforming loans.  Although we believe that we had establishedadequate allowances for credit losses as of March 31, 2005, the credit qualityof our assets is affected by many factors beyond our control, including localand national economic conditions, and the possible existence of facts which arenot known to us which adversely affect the likelihood of repayment of variousloans in our loan portfolio and realization of the collateral upon adefault.  Accordingly, we can give noassurance that we will not sustain loan losses materially in excess of theallowance for credit losses.  Inaddition, the Office of the Comptroller of the Currency, as an integral part ofits examination process, periodically reviews our allowance for credit lossesand could require additional provisions for credit losses.  Material future additions to the allowancefor credit losses may also be necessary due to increases in the size andchanges in the composition of our loan portfolio.  Increases in our provisions for credit losseswould adversely affect our results of operations.

 

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**Economic conditions may worsen.**

 

Our business isstrongly influenced by economic conditions in our market area (principally, thegreater Los Angeles metropolitan area) as well as regional and nationaleconomic conditions and in our niche markets, including the entertainmentindustry in Southern California.  Shouldthe economic condition in these areas worsen, the financial condition of ourborrowers could weaken, which could lead to higher levels of loan defaults or adecline in the value of collateral for our loans.  In addition, an unfavorable economy couldreduce the demand for our loans and other products and services.

 

**Because a significant amount of the loans we makeare to borrowers in California, our operations could suffer as a result oflocal recession or natural disasters in California.**

 

At March 31, 2005,a large majority of our loans outstanding were collateralized by realproperties located in California. Because of this concentration in California, our financial position andresults of operations have been and are expected to continue to be influencedby general trends in the California economy and its real estate market.  Real estate market declines may adverselyaffect the values of the properties collateralizing loans.  If the principal balances of our loans,together with any primary financing on the mortgaged properties, equal orexceed the value of the mortgaged properties, we could incur higher losses onsales of properties collateralizing foreclosed loans.  In addition, California historically has beenvulnerable to certain natural disaster risks, such as earthquakes anderosion-caused mudslides, which are not typically covered by the standardhazard insurance policies maintained by borrowers.  Uninsured disasters may adversely impact ourability to recover losses on properties affected by such disasters andadversely impact our results of operations.

 

**Our business is very competitive.**

 

There is intensecompetition in Southern California and elsewhere in the United States forbanking customers.  We experiencecompetition for deposits from many sources, including credit unions, insurancecompanies and money market and other mutual funds, as well as other commercialbanks and savings institutions.  Wecompete for loans and deposits primarily with other commercial banks, mortgagecompanies, commercial finance companies and savings institutions.  In recent years out-of-state financial institutionshave entered the California market, which has also increased competition.  Many of our competitors have greaterfinancial strength, marketing capability and name recognition than we do, andoperate on a statewide or nationwide basis. In addition, recent developments in technology and mass marketing havepermitted larger companies to market loans more aggressively to our smallbusiness customers.  Such advantages maygive our competitors opportunities to realize greater efficiencies andeconomies of scale than we can.  We canprovide no assurance that we will be able to compete effectively against ourcompetition.

 

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**Our business is heavily regulated.**

 

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

 

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

 

Statement ofFinancial Accounting Standards No. 142 “Goodwill and Other Intangible Assets” (“SFASNo. 142”), among other provisions, prescribes that goodwill and intangibleassets that have indefinite useful lives will not be amortized but rathertested annually, or more frequently upon the occurrence of certain events, forimpairment.  SFAS No. 142 providesspecific guidance for the testing of goodwill for impairment, which may requirere-measurement of the fair value of the reporting unit.  Impairment losses are to be reported as acharge to current period earnings.

We recordedgoodwill of $3.2 million in connection with the South Bay acquisition inDecember 2001.  During the fourth quarterof 2004, we completed the required impairment tests of goodwill.  The tests determined that our goodwill wasnot considered impaired.  No assurancecan be given that our goodwill will not become impaired in the future.

 

**Wedetermine annually whether our deferred tax asset will be realized and mustestablish a valuation allowance if necessary to reduce it to its realizablevalue.**

 

On a periodicbasis, at least annually, we perform an analysis to determine if it is morelikely than not that some or all of the gross deferred tax asset will not berealized.  Factors used in the analysisthat are reflective of the future realization of a deferred tax asset are:

•                  Future earnings are likely;

•                  Expected future taxable income arisingfrom the reversal of temporary differences adequate to realize the tax asset

A valuationallowance may be established to reduce the deferred tax asset to its realizablevalue.  The determination of whether avaluation allowance is necessary involves considering the positive and negativefactors related to whether the deferred tax asset is more likely than not to berealized.  Any adjustment required to thevaluation allowance is coupled with a related entry to income tax expense.  A charge to earnings will be made in theevent that we determine that a valuation allowance to the deferred tax asset isnecessary.  No such valuation allowanceexisted at March 31, 2005.

 

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CAUTIONARY NOTE REGARDING FORWARD-LOOKINGSTATEMENTS

 

This report containsforward-looking statements about the Company. Forward-looking statements consist of description of plans or objectivesfor future operations, products or services, forecasts of revenues, earnings orother measures of economic performance and assumptions underlying or relatingto any of the foregoing.  Becauseforward-looking statements discuss future events or conditions and nothistorical facts, they often include words such as “anticipate,” “believe,” “estimate,”“expect,” “intend,” “plan,” “project,” “target,” “can,” “could,” “may,” “should”or similar expressions.   Do not relyunduly on forward-looking statements. They give the Company’s expectations about the future and are notguarantees or predictions of futures events, conditions or results.  Forward-looking statements speak only as ofthe date they are made, and the Company does not undertake to update them toreflect changes that occur after that date.

Many factors, mostbeyond the Company’s control, could cause actual results to differ significantlyfrom the Company’s expectations   Theseinclude, among other things, changes in interest rates which reduce interestmargins, impact funding sources or diminish loan demand; increased competitivepressures; adverse changes in national and local economic conditions, and inreal estate markets in California; changes in fiscal policy, monetary policy;legislative or regulatory environments, requirements or changes which adverselyaffect the Company; and declines in the credit quality of the Company’s loanportfolio.  See “Factors Which May AffectFuture Operating Results.”

 

 

***ITEM 3. CONTROLSAND PROCEDURES***

 

The Companymaintains disclosure controls and procedures (as defined in Exchange Act Rule13a-15(e)) that are designed to assure that information required to bedisclosed in its Exchange Act reports is recorded, processed, summarized andreported within the time periods specified in the Securities and ExchangeCommission’s rules and forms, and that such information is accumulated andcommunicated to management, including the Chief Executive Officer and ChiefFinancial Officer, as appropriate, to allow timely decisions regarding requireddisclosures.

In designing andevaluating the disclosure controls and procedures, management recognizes thatany controls and procedures, no matter how well designed and operated, canprovide reasonable assurance only of achieving the desired control objectives,and management necessarily is required to apply its judgment in weighting thecosts and benefits of possible new or different controls and procedures.  Limitations are inherent in all controlsysytems, so no evaluation of controls can provide absolute assurance that allcontrol issues and any fraud within the company have been detected.

 

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As required byExchange Act Rule 13a-15(b), as of the end of the period covered by this reportthe Company, under  the supervision andwith the participation of our Chief Executive Officer and Chief FinancialOfficer, evaluated the effectiveness of the Company’s disclosure controls andprocedures.  Based on this evaluation,our Chief Executive Officer and Chief financial Officer concluded that theCompany’s disclosure controls and procedures were effective as of that date.

There was nochange in the Company’s internal control over financial reporting during theCompany’s most recently completed fiscal quarter that has materially affected,or is reasonably likely to materially affect, the Company’s internal controlover financial reporting.

 

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**PART II—OTHERINFORMATION**

 

***Item 1.       LEGAL PROCEEDINGS***

 

None.

 

***Item 2.       UNREGISTEREDSALES OF EQUITY SECURITIES AND USE OF PROCEEDS***

 

None.

 

***Item 3.       DEFAULTS UPON SENIOR SECURITIES***

 

None.

 

***Item 4.       SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS***

 

None.

 

***Item 5.       OTHERINFORMATION***

 

None.

 

***Item 6.       EXHIBITS***

 

 

31.1 Certification of Scott A. Montgomery on disclosurecontrols.

31.2 Certification of David R. Brown on disclosure controls.

32.1 Certification of Scott A. Montgomery pursuant to section906 of the Sarbanes-Oxley Act of 2002

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

 

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**SIGNATURES**

 

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

 
|              |         | **National Mercantile Bancorp**               |   |
|-------------------|--------------|-----------------------------------------------|--------|
|              |         | (Registrant)                                  |   |
|              |         |                                          |   |
| DATE:   | May 13, 2005 | /s/ SCOTT  A. MONTGOMERY                      |   |
|              |         | **Scott A. Montgomery**                       |   |
|              |         | Chief  Executive Officer                      |   |
|              |         |                                          |   |
| DATE:   | May 13, 2005 | /s/ DAVID  R. BROWN                           |   |
|              |         | **David R. Brown**                            |   |
|              |         | Principal  Financial and Principal Accounting |   |
|              |         | Officer                                       |   |

 

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