**UNITEDSTATES****SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**Form 10-QSB/A**

**(AmendmentNo. 1)**

x  **Quarterly report under section 13 or 15(d) of the Securities ExchangeAct of 1934**

**for thequarterly period ended March 31, 2006**

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 ofsmall business issuer in its charter)

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

 

Issuer’s 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 filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.    o  Yes      x  No

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

The number of shares ofCommon Stock, no par value, of the issuer outstanding as of September 18, 2006was 5,550,767.

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

 

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**ExplanatoryNote**

NationalMercantile Bancorp (the “Company”) is filing this amendment to Form 10-QSBfor the quarter ended March 31, 2006, to amend and restate historicalfinancial statements and other financial information filed with the Securitiesand Exchange Commission (“SEC”). These amendments are being filed to correcterrors in the originally filed Form 10-QSB related to the Company’sderivative accounting under Statement of Financial Accounting StandardsNo. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS No. 133”).

Thisamendment restates the consolidated financial statements and the otherfinancial information as of and for the three months ended March 31, 2006. Therestatement has the following impact on Net Income and Dilute Earnings PerCommon Share by period:

**Impact**
|        | ** ** | **Net Income  Adjustment** | ** ** | **Diluted  EPS  Adjustment** | ** ** |
|--------|------------|---------------------------------|------------|------------------------------|------------|
|   | ** ** | **(Dollars in  thousands)**     | ** ** | ** **                   | ** ** |
|   |       |                            |       |                         |       |
| 1Q06   |       | $                               | (262       | )                            | (0.04      | ) |
|        |            |                                 |            |                              |            |  |

 

Foradditional information relating to the effect of the restatement, see thefollowing items:
| Part I |                                                                                                 |
|--------|------------------------------------------------------------------------------------------------------|
|   | Item 1. Financial  Statements                                                                        |   |
|   | Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of  Operations |   |

 

2

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PART I – FINANCIAL INFORMATION

*Item1.  Financial Statements*

Presented are the unaudited consolidated financialstatements of National Mercantile Bancorp (“National Mercantile” on aparent-only basis, and the “Company” on a consolidated basis) and its wholly-ownedsubsidiaries, Mercantile National Bank (“Mercantile”) and South Bay Bank, N.A.(“South Bay”), (collectively, the “Banks”).

3

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**NATIONALMERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

(Unaudited)
| ** **                                                                                                                                                 | ** ** | **March 31,**                                  | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                 | ** ** | **2006**                                            | ** ** | **2005**              | ** ** |
| ** **                                                                                                                                                 | ** ** | **(Dollars in thousands, restated)** | ** ** |
| ASSETS                                                                                                                                                     |       |                                                |       |                  |       |
| Cash and due from  banks-demand                                                                                                                            |       | $                                                   | 15,211     |                  | $          | 13,507 |   |
| Due from banks-interest  bearing                                                                                                                           |       | 2,000                                               |       | 2,000                 |       |
| Federal funds sold                                                                                                                                         |       | 2,790                                               |       | 685                   |       |
| Cash and cash  equivalents                                                                                                                                 |       | 20,001                                              |       | 16,192                |       |
| Securities available-for-sale,  at fair value;   aggregate amortized cost of $87,278 and $72,428 at   March 31, 2006 and December 31, 2005, respectively   |       | 85,825                                              |       | 71,758                |       |
| Securities  held-to-maturity, at amortized cost;   aggregate fair value of $2,370 and $2,572 at   March 31, 2006 and December 31, 2005, respectively       |       | 2,438                                               |       | 2,612                 |       |
| Federal Reserve Bank  and other stock                                                                                                                      |       | 3,940                                               |       | 3,809                 |       |
| Loans receivable                                                                                                                                           |       | 353,500                                             |       | 338,558               |       |
| Allowance for  credit losses                                                                                                                               |       | (4,562                                              | )          | (4,468                | )          |
| Net loans  receivable                                                                                                                                      |       | 348,938                                             |       | 334,090               |       |
|                                                                                                                                                       |       |                                                |       |                  |       |
| Premises and equipment,  net                                                                                                                               |       | 5,877                                               |       | 5,861                 |       |
| Other real estate owned                                                                                                                                    |       | —                                              |       | 1,056                 |       |
| Deferred tax asset, net                                                                                                                                    |       | 4,289                                               |       | 4,442                 |       |
| Goodwill                                                                                                                                                   |       | 3,225                                               |       | 3,225                 |       |
| Intangible assets, net                                                                                                                                     |       | 1,351                                               |       | 1,407                 |       |
| Accrued interest  receivable and other assets                                                                                                              |       | 3,448                                               |       | 4,008                 |       |
| Total assets                                                                                                                                               |       | $                                                   | 479,332    |                  | $          | 448,460 |   |
|                                                                                                                                                       |       |                                                |       |                  |       |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY                                                                                                                 |       |                                                |       |                  |       |
| Deposits:                                                                                                                                                  |       |                                                |       |                  |       |
| Noninterest-bearing  demand                                                                                                                                |       | $                                                   | 122,638    |                  | $          | 115,924 |   |
| Interest-bearing  demand                                                                                                                                   |       | 31,716                                              |       | 36,018                |       |
| Money market                                                                                                                                               |       | 91,885                                              |       | 76,334                |       |
| Savings                                                                                                                                                    |       | 26,336                                              |       | 28,208                |       |
| Time  certificates of deposit:                                                                                                                             |       |                                                |       |                  |       |
| $100,000 or more                                                                                                                                           |       | 114,296                                             |       | 87,468                |       |
| Under $100,000                                                                                                                                             |       | 18,481                                              |       | 19,256                |       |
| Total deposits                                                                                                                                             |       | 405,352                                             |       | 363,208               |       |
|                                                                                                                                                       |       |                                                |       |                  |       |
| Securities sold under  agreement to repurchase                                                                                                             |       | 15,000                                              |       | —                |       |
| Other borrowings                                                                                                                                           |       | 1,400                                               |       | 28,337                |       |
| Junior subordinated  deferrable interest debentures                                                                                                        |       | 15,464                                              |       | 15,464                |       |
| Accrued interest  payable and other liabilities                                                                                                            |       | 3,414                                               |       | 3,288                 |       |
| Total  liabilities                                                                                                                                         |       | 440,630                                             |       | 410,297               |       |
|                                                                                                                                                       |       |                                                |       |                  |       |
| Shareholders’ equity:                                                                                                                                 |       |                                                |       |                  |       |
| Preferred stock,  no par value-authorized 1,000,000 shares:                                                                                                |       |                                                |       |                  |       |
| Series B  non-cumulative convertible perpetual preferred stock; authorized 1,000  shares; outstanding 1,000 shares at March 31, 2006 and December 31, 2005 |       | 1,000                                               |       | 1,000                 |       |
| Common stock, no  par value-authorized 10,000,000 shares:                                                                                                  |       |                                                |       |                  |       |
| outstanding  5,541,280 shares and 5,503,780 shares at March 31, 2006 and December 31,  2005, respectively                                                  |       | 45,976                                              |       | 45,697                |       |
| Accumulated  deficit                                                                                                                                       |       | (6,324                                              | )          | (7,380                | )          |
| Accumulated  other comprehensive loss                                                                                                                      |       | (1,950                                              | )          | (1,154                | )          |
| Total  shareholders’ equity                                                                                                                           |       | 38,702                                              |       | 38,163                |       |
| Total liabilities and  shareholders’ equity                                                                                                           |       | $                                                   | 479,332    |                  | $          | 448,460 |   |

 

Seeaccompanying notes to consolidated financial statements.

4

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**NATIONALMERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

(Unaudited)
| ** **                                                              | ** ** | **For the Three Months Ended**       | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                              | ** ** | **March 31,**                                       | ** ** |
| ** **                                                              | ** ** | **2006**                                                 | ** ** | **2005** | ** ** |
| ** **                                                              | ** ** | **(Dollars in thousands,**                     | ** ** |
| ** **                                                              | ** ** | **except per share data, restated)** | ** ** |
| Interest income:                                                        | ** ** | ** **                                               | ** ** | ** ** | ** ** |
| Loans, including fees                                                   |       | $                                                        | 7,040      |   | $ | 5,443 |   |
| Securities                                                              |       | 985                                                      |       | 368 |   |
| Due from banks                                                          |       | 21                                                       |       | 16 |   |
| Federal funds sold and securities purchased under  agreements to resell |       | 5                                                        |       | 10 |   |
| Total interest income                                                   |       | 8,051                                                    |       | 5,837 |   |
| Interest  expense:                                                      |       |                                                     |       |   |   |
| Interest-bearing demand                                                 |       | 42                                                       |       | 32 |   |
| Money market and savings                                                |       | 584                                                      |       | 220 |   |
| Time certificates of deposit:                                           |       |                                                     |       |   |   |
| $100,000 or more                                                        |       | 768                                                      |       | 208 |   |
| Under $100,000                                                          |       | 176                                                      |       | 142 |   |
| Total interest expense on deposits                                      |       | 1,570                                                    |       | 602 |   |
| Securities sold under agreements to repurchase                          |       | 145                                                      |       | — |   |
| Other borrowings                                                        |       | 224                                                      |       | 94 |   |
| Junior subordinated deferrable interest debentures                      |       | 396                                                      |       | 396 |   |
| Total interest expense                                                  |       | 2,335                                                    |       | 1,092 |   |
| Net interest income before provision for credit  losses                 |       | 5,716                                                    |       | 4,745 |   |
| Provision for  credit losses                                            |       | 32                                                       |       | 89 |   |
| Net interest income after provision for credit  losses                  |       | 5,684                                                    |       | 4,656 |   |
| Other operating  income:                                                |       |                                                     |       |   |   |
| Trading losses on non-hedge derivatives                                 |       | (448                                                     | )          | (204 | ) |
| Net settlement on interest rate swap                                    |       | 43                                                       |       | 116 |   |
| International services                                                  |       | 33                                                       |       | 10 |   |
| Investment division                                                     |       | 9                                                        |       | 15 |   |
| Deposit-related and other customer services                             |       | 232                                                      |       | 297 |   |
| Gain on sale of other real estate owned                                 |       | 48                                                       |       | — |   |
| Total other operating income                                            |       | (83                                                      | )          | 234 |   |
| Other operating  expenses:                                              |       |                                                     |       |   |   |
| Salaries and related benefits                                           |       | 2,089                                                    |       | 1,838 |   |
| Net occupancy                                                           |       | 261                                                      |       | 246 |   |
| Furniture and equipment                                                 |       | 133                                                      |       | 127 |   |
| Printing and communications                                             |       | 166                                                      |       | 145 |   |
| Insurance and regulatory assessments                                    |       | 99                                                       |       | 108 |   |
| Client services                                                         |       | 142                                                      |       | 172 |   |
| Computer data processing                                                |       | 217                                                      |       | 232 |   |
| Legal services                                                          |       | 74                                                       |       | 148 |   |
| Other professional services                                             |       | 304                                                      |       | 254 |   |
| Amortization of core deposit intangible                                 |       | 56                                                       |       | 56 |   |
| Promotion and other expenses                                            |       | 191                                                      |       | 160 |   |
| Total other operating expenses                                          |       | 3,732                                                    |       | 3,486 |   |
| Income before  income tax provision                                     |       | 1,869                                                    |       | 1,404 |   |
| Income tax  provision                                                   |       | 813                                                      |       | 582 |   |
| Net income                                                              |       | $                                                        | 1,056      |   | $ | 822 |   |
| Earnings per  share:                                                    |       |                                                     |       |   |   |
| Basic                                                                   |       | $                                                        | 0.19       |   | $ | 0.22 |   |
| Diluted                                                                 |       | $                                                        | 0.18       |   | $ | 0.14 |   |

 

Seeaccompanying notes to consolidated financial statements.

5

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**NATIONALMERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

(Unaudited)
| ** **                                                                                  | ** ** | **For the Three Months Ended March 31,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                                                                  | ** ** | **2006**                                                               | ** ** | **2005** | ** ** |
| ** **                                                                                  | ** ** | **(Dollars in thousands, restated)**                    | ** ** |
| Cash flows from  operating activities:                                                      |       |                                                                   |       |   |   |
| Net income                                                                                  |       | $                                                                      | 1,056      |   | $ | 822 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities:          |       |                                                                   |       |   |   |
| Depreciation and amortization                                                               |       | 116                                                                    |       | 103 |   |
| Provision for credit losses                                                                 |       | 32                                                                     |       | 89 |   |
| Trading loss on non-hedge derivatives                                                       |       | 448                                                                    |       | 204 |   |
| Gain on sale of other real estate owned                                                     |       | (48                                                                    | )          | — |   |
| Net amortization of discount on securities  available-for-sale                              |       | (21                                                                    | )          | 19 |   |
| Net amortization of premium on securities  held-to-maturity                                 |       | 5                                                                      |       | 8 |   |
| Net amortization of core deposit intangible                                                 |       | 56                                                                     |       | 56 |   |
| Net amortization of premium on loans purchased                                              |       | 32                                                                     |       | 41 |   |
| Utilization of deferred tax assets                                                          |       | 759                                                                    |       | — |   |
| Decrease (increase) in accrued interest receivable  and other assets                        |       | (473                                                                   | )          | 382 |   |
| Increase (decrease) in accrued interest payable and  other liabilities                      |       | 187                                                                    |       | (668 | ) |
| Net cash provided by operating activities                                                   |       | 2,149                                                                  |       | 1,056 |   |
| Cash flows from  investing activities:                                                      |       |                                                                   |       |   |   |
| Purchase of securities available-for-sale                                                   |       | (24,513                                                                | )          | (536 | ) |
| Proceeds from repayments and maturities of  securities available-for-sale                   |       | 10,114                                                                 |       | 1,336 |   |
| Proceeds from repayments and maturities of  securities held-to-maturity                     |       | 169                                                                    |       | 215 |   |
| Loan originations and principal collections, net                                            |       | (14,973                                                                | )          | 4,219 |   |
| Proceeds from sale of other real estate owned                                               |       | 1,104                                                                  |       | — |   |
| Purchase of Federal Reserve stock and other stocks                                          |       | (595                                                                   | )          | (195 | ) |
| Purchases of premises and equipment                                                         |       | (132                                                                   | )          | (140 | ) |
| Net cash provided by (used in) investing activities                                         |       | (28,826                                                                | )          | 4,899 |   |
| Cash flows from  financing activities:                                                      |       |                                                                   |       |   |   |
| Net increase in demand deposits, money market and  savings accounts                         |       | 16,091                                                                 |       | 6,777 |   |
| Net increase in time certificates of deposit                                                |       | 26,053                                                                 |       | 5,456 |   |
| Net increase in securities sold under agreements to  repurchase and federal funds purchased |       | 15,000                                                                 |       | — |   |
| Net decrease in other borrowings                                                            |       | (26,937                                                                | )          | (16,000 | ) |
| Net proceeds from exercise of stock options                                                 |       | 279                                                                    |       | 187 |   |
| Net cash provided by (used in) financing activities                                         |       | 30,486                                                                 |       | (3,580 | ) |
| Net increase in  cash and cash equivalents                                                  |       | 3,809                                                                  |       | 2,375 |   |
| Cash and cash  equivalents, January 1                                                       |       | 16,192                                                                 |       | 16,915 |   |
| Cash and cash  equivalents, March 31                                                        |       | $                                                                      | 20,001     |   | $ | 19,290 |   |
|                                                                                        |       |                                                                   |       |   |   |
| Supplemental  disclosures of cash flow information:                                         |       |                                                                   |       |   |   |
| Cash paid for interest                                                                      |       | $                                                                      | 2,112      |   | $ | 1,205 |   |
| Cash paid for income taxes                                                                  |       | 325                                                                    |       | 290 |   |
| Unrealized loss on securities available-for-sale,  net of tax effect                        |       | 353                                                                    |       | 173 |   |
| Unrealized loss  on cash flow hedges, net of tax effect                                     |       | $                                                                      | 1,076      |   | $ | 636 |   |

 

See accompanying notes to consolidated financial statements.

6

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**NATIONALMERCANTILE BANCORP AND SUBSIDIARIES**

###### **NOTES TO THECONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

NOTE 1—RESTATEMENT

National MercantileBancorp has restated its consolidated financial statements as of and for thethree months ended March 31, 2006 and for the years ended December 31,2005, 2004 and 2003 as well as for each of the interim periods in 2005, 2004and 2003. This restatement corrected errors related to the Company’s derivativeaccounting under Statement of Financial Accounting Standards No. 133,Accounting for Derivative Instruments and Hedging Activities (“SFAS No. 133”).

In 2003, the Companyentered into an interest rate swap agreement in connection with the trustpreferred securities related to the Company’s junior subordinated deferrableinterest debentures (Trust Preferred Swap) that was accounted for as a fairvalue hedge under SFAS No. 133. The Company elected an abbreviated method(the “short-cut” method) of documenting the effectiveness of the swap as ahedge, which allowed the Company to assume no ineffectiveness in thistransaction. As a result of later technical interpretations of SFAS 133, theCompany subsequently concluded that the Trust Preferred Swap did notqualify for this method in prior periods. The presence of an interest deferral feature in the interest rate swapwas determined, in retrospect, to have caused the interest rate swap to nothave a fair value of zero at inception, which is required under SFAS 133 toqualify for short-cut hedge accounting treatment.  Hedge accounting under SFAS No. 133for this swap transaction is not allowed retrospectively because the hedgedocumentation required for the long-haul method was not in place at theinception of the hedge. Eliminating the application of fair value hedgeaccounting reverses the fair value adjustments that were made to the hedgeditem, the debt, as an adjustment to the par amount of the Trust Preferreddebt. This reversal of fair value hedge accounting also results inreclassification of swap net settlements from interest expense to noninterestincome as well as recording of swap mark-to-market adjustments in trading gains(losses) on economic derivatives.

The following table setsforth the effects of the adjustments to net income for the three months endedMarch 31, 2006.  Since the Company couldnot apply hedge accounting for the transaction, the Trust Preferred Swap hasbeen marked-to-market through the consolidated statement of operations with norelated offset for hedge accounting.

7

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|                                        | ** ** | **Three months** | ** ** |
|----------------------------------------|------------|-----------------------|------------|
| ** **                             | ** ** | **ended**             | ** ** |
| ** **                             | ** ** | **March 31,**    | ** ** |
| ** **                             | ** ** | **2006**              | ** ** |
| Net income as  previously reported     |       | $                     | 1,318      |   |
|                                   |       |                  |       |
| Trading loss on  non-hedge derivatives |       | (448                  | )          |
| Benefit for  income taxes              |       | 186                   |       |
| Total adjustment                       |       | (262                  | )          |
|                                   |       |                  |       |
| Restated net  income                   |       | $                     | 1,056      |   |
|                                   |       | -19.88                | %          |

 

The following tablesreflect the previously reported amounts and the restated results by financialstatement line item for the consolidated balance sheet and statement ofstockholders’ equity as of March 31, 2006 and the consolidated statementsof income for the three months then ended.
|                                                  | ** ** | **March 31,**                   | ** ** |
|--------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                       | ** ** | **2006**                             | ** ** |
| ** **                                       | ** ** | **As  Originally  Reported**         | ** ** | **As  Restated** | ** ** |
| ** **                                       | ** ** | **(Dollars in thousands)** | ** ** |
| Consolidated  balance sheets:                    |       |                                 |       |   |   |
| Deferred tax asset, net                          |       | $                                    | 3,864      |   | $ | 4,289 |   |
| Accrued interest receivable and other assets     |       | 4,471                                |       | 3,448 |   |
| Total assets                                     |       | 479,930                              |       | 479,332 |   |
| Accumulated deficit                              |       | (5,726                               | )          | (6,324 | ) |
| Total shareholders’ equity                  |       | 39,300                               |       | 38,702 |   |
| Total  liabilities and shareholders’ equity |       | 479,930                              |       | 479,332 |   |
|                                                  |            |                                      |            |  |  |  |  |

 

8

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|                                                         | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                              | ** ** | **March 31, 2006**     | ** ** |
| ** **                                              | ** ** | **As  Originally  Reported**     | ** ** | **Restated** | ** ** |
| Consolidated  Statements of Operations:                 |       |                             |       |   |   |
| Interest expense:                                       |       |                             |       |   |   |
| Junior subordinated deferrable interest debentures      |       | $                                | 353        |   | $ | 396 |   |
| Total interest expense                                  |       | 2,292                            |       | 2,335 |   |
| Net interest income before provision for credit  losses |       | 5,759                            |       | 5,716 |   |
| Net interest income after provision for credit  losses  |       | 5,727                            |       | 5,684 |   |
| Trading gains (losses) on economic derivatives          |       | —                           |       | (448 | ) |
| Net cash settlement of interest rate swap derivative    |       | —                           |       | 43 |   |
| Total other operating income                            |       | 322                              |       | (83 | ) |
| Income before income tax provision                      |       | 2,317                            |       | 1,869 |   |
| Income tax provision                                    |       | 999                              |       | 813 |   |
| Net income                                              |       | 1,318                            |       | 1,056 |   |
| Earnings per share – basic(1)                      |       | 0.24                             |       | 0.19 |   |
| Earnings per  share – diluted(1)                   |       | 0.22                             |       | 0.18 |   |
|                                                         |            |                                  |            |  |  |  |  |

 

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(1)  Adjusted for the 5- for 4-stock split paidApril 16, 2006

In addition, thefollowing Notes to Consolidated Financial Statements have been restated: 2,3,10, and 11.

NOTE 2—BASIS OF PRESENTATION AND MANAGEMENTREPRESENTATIONS

The unauditedconsolidated financial statements include the accounts of National MercantileBancorp (“National Mercantile” on a parent-only basis, and the “Company” on aconsolidated basis) and its wholly-owned subsidiaries, Mercantile National Bankand South Bay Bank, N.A., (collectively, the “Banks”).  The unaudited consolidated financialstatements of the Company reflect all interim adjustments, which are of anormal recurring nature and which, in management’s opinion, are necessary forthe fair presentation of the Company’s consolidated financial position andresults of operations and cash flows for such interim periods. The results forthe three months ended March 31, 2006 are not necessarily indicative of theresults expected for any subsequent period or for the full year ending December31, 2006.  The unaudited consolidatedfinancial statements should be read in conjunction with the auditedconsolidated financial statements included in the Company’s Annual Report onForm 10-KSB for the year ended December 31, 2005.

9

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NOTE 3—EARNINGS PER SHARE

Basic earnings per shareis computed using the weighted average number of common shares outstandingduring the period.  The number of shareshas been adjusted for the five-for-four stock split effected in the form of astock dividend paid April 14, 2006 and reflect the conversion of the Series APreferred Stock in June 2005.

The following table is areconciliation of income and shares used in the computation of basic anddiluted earnings per share: 
|                                               | ** ** | ** **                                                                                     | ** ** | **Weighted** | ** ** | ** **         | ** ** |
|-----------------------------------------------|------------|------------------------------------------------------------------------------------------------|------------|--------------|------------|--------------------|------------|
| ** **                                    | ** ** | ** **                                                                                     | ** ** | **Average**  | ** ** | **Per share** | ** ** |
| ** **                                    | ** ** | **Net Income**                                                                            | ** ** | **Shares**   | ** ** | **amount**         | ** ** |
| ** **                                    | ** ** | **(Dollars in thousands, except per share data, restated)** | ** ** |
| ** **                                    | ** ** | ** **                                                                                     | ** ** | ** **   | ** ** | ** **         | ** ** |
| *For the  three months ended March 31, 2006:* |       |                                                                                           |       |         |       |               |       |
| Basic earnings per share                      |       | $                                                                                              | 1,056      |         | 5,518,383  |               | $          | 0.19 |   |
|                                          |       |                                                                                           |       |         |       |               |       |
| Effect of dilutive securities:                |       |                                                                                           |       |         |       |               |       |
| Options                                       |       |                                                                                           |       | 267,414      |       |               |       |
| Convertible preferred stock                   |       |                                                                                           |       | 216,664      |       |               |       |
| Diluted earnings per share                    |       | $                                                                                              | 1,056      |         | 6,002,461  |               | $          | 0.18 |   |
|                                          |       |                                                                                           |       |         |       |               |       |
| *For the  three months ended March 31, 2005:* |       |                                                                                           |       |         |       |               |       |
| Basic earnings per share                      |       | $                                                                                              | 822        |         | 3,716,154  |               | $          | 0.22 |   |
|                                          |       |                                                                                           |       |         |       |               |       |
| Effect of dilutive securities:                |       |                                                                                           |       |         |       |               |       |
| Options                                       |       |                                                                                           |       | 246,269      |       |               |       |
| Convertible preferred stock                   |       |                                                                                           |       | 1,851,363    |       |               |       |
| Diluted earnings  per share                   |       | 822                                                                                            |       | 5,813,785    |       | $                  | 0.14       |   |

 

NOTE 4—CASH AND CASH EQUIVALENTS

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

NOTE 5—ALLOWANCE FOR LOAN AND LEASE LOSSES

The allowance for loanand lease losses is a valuation adjustment used to recognize impairment of therecorded investment in the Company’s loans receivable on its balance sheetbefore losses have been confirmed resulting in a subsequent charge-off or write-down.

Provisions for creditlosses charged (or credited) to operations reflect management’s judgment of theadequacy of the allowance for loan and lease losses and are determined throughperiodic analysis of the loan portfolio. This analysis includes a systematic and detailed review of theclassification and categorization of problem loans; an assessment of theoverall quality

10

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and collectibility of the portfolio; andconsideration of the loan loss experience, trends in problem loans,concentrations of credit risk, as well as current economic conditions(particularly Southern California). Management performs a periodic risk and credit analysis, the results ofwhich are reported to the Board of Directors.

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

The following table setsforth information concerning the Company’s allowance for credit losses for theperiods indicated.

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

 

Credit quality isaffected by many factors beyond the control of the Company, including local andnational economies, and facts may exist which are not known to the Company thatadversely affect the likelihood of repayment of various loans in the loanportfolio and realization of collateral upon a default.  Accordingly, no assurance can be given thatthe Company will not sustain loan losses materially in excess of the allowancefor credit losses. In addition, the Office of the Comptroller of the Currency (“OCC”),as an integral part of its examination process, periodically reviews theallowance for credit losses and could require additional provisions for creditlosses.

11

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NOTE 6—GOODWILL AND CORE DEPOSIT INTANGIBLES

As of March 31, 2006 andDecember 31, 2005, the Company had goodwill of $3.2 million, and net coredeposit intangibles of $1.4 million from its acquisition of South Bay Bank inDecember 2001.  The gross carrying amountof core deposit intangibles was $2.3 million at March 31, 2006 and December 31,2005, and accumulated amortization was $949,000 and $893,000, respectively, atsuch dates.  The core deposit intangiblesare estimated to have a life of 10 years and 4 months.  Amortization of intangibles for 2006 and eachof the next four years is estimated to be $223,000 per year.  In accordance with SFAS No. 142 goodwill isnot amortized.  The Company has no otherrecorded indefinite-lived intangible assets. Goodwill and other intangible assets are reviewed and assessed annuallyfor impairment or more frequently if conditions suggest impairment may exist.

NOTE 7—REPURCHASE AGREEMENTS

At March 31, 2006, theCompany had $15.0 million of securities sold under agreement to repurchase (“RepurchaseAgreements”).  At December 31, 2005,there were no Repurchase Agreements.  TheRepurchase Agreements entered into during the first quarter 2006 areadjustable, indexed to LIBOR, and contain embedded interest rate floors with a4.0% strike rate for a term of two years and were utilized to facilitate theCompany’s liquidity and interest rate risk management objectives.  In the event of a sustained decline ininterest rates, upon reaching the strike rate, the cost of the RepurchaseAgreements will decline at double the difference between the index rate and thestrike rate, but in any event, not below zero.

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

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NOTE 8—INCOME TAXES

Income tax provisions of$813,000 and $582,000 were recorded for the three months ended March 31, 2006and 2005, respectively.

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

Management believes thatit is more likely than not that the deferred tax asset, a portion of which iscomprised of the NOLS, will be realized. Accordingly, no valuation allowance has been established against thedeferred tax asset.

NOTE 9—SHARE-BASED PAYMENTS

At March 31, 2006,the Company had one stock incentive plan pursuant to which up to a total of312,500 shares of common stock may be issued. Under this plan, the Company may grant to directors, officers, employeesand consultants stock-based incentive compensation in a variety of forms,including without limitation nonqualified options, incentive options, sales andbonuses of common stock and stock appreciation rights, on such terms andconditions as the Board of Directors of the Company determines.  The term of the stock option may not exceed10 years.  Employee stock option grantsgenerally vest over one year or ratable over two years.  Director stock options vest in one year.  All stock options have vesting conditionsthat include only service conditions; none of the grants contains performanceor market vesting conditions.

The Company issues newshares upon the exercise of stock options. All of the share-based payment awards qualify for classification asequity.  At March 31, 2006, the onlyoutstanding awards under this plan were stock options, and at that date 193,430shares were available for future awards. At March 31, 2006, there were also outstanding options grantedunder two prior stock incentive plans. The activity of stock options for the three months ended March 31, 2006is as shown:
|                                 | ** ** | **No. of  Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|---------------------------------|------------|-------------------------|------------|--------------------------------------------|------------|-----------------------------------------------------|------------|-------------------------------------|------------|
| Outstanding, December  31, 2005 |       | 519,358                 |       | $                                          | 9.62       |                                                | 6.3        |                                | $          | 4,996,224 |   |
| Granted                         |       | 3,100                   |       | 18.19                                      |       | 9.8                                                 |       | 56,389                              |       |
| Exercised                       |       | (29,750                 | )          | 7.54                                       |       | 5.3                                                 |       | 224,315                             |       |
| Forefeited                      |       | (6,750                  | )          | 12.40                                      |       | 9.0                                                 |       | 83,700                              |       |
| Expired                         |       | —                  |       | —                                     |       | —                                              |       | —                              |       |
| Five-for-four  stock split      |       | 121,490                 |       | n/a                                        |       | n/a                                                 |       | n/a                                 |       |
| Outstanding, March 31,  2006    |       | 607,448                 |       | $                                          | 7.81       |                                                | 6.0        |                                | 4,744,165  |   |
| Exercisable, March 31,  2006    |       | 382,659                 |       | $                                          | 5.95       |                                                | 4.6        |                                | 2,276,821  |   |
| Unvested, March 31,  2006       |       | 224,789                 |       | $                                          | 8.68       |                                                | 8.7        |                                | 1,951,164  |   |
|                                 |            |                         |            |                                            |            |                                                     |            |                                     |            |  |  |

 

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The Financial AccountingStandards Board issued Statement of Financial Accounting Standards No. 123R, “Share-BasedPayment” (SFAS 123R) which eliminated the ability to account for share-basedcompensation transactions, including grants of employee stock options, usingAccounting Principles Board Opinion No. 25, “Accounting for Stock Issuedto Employees” (APB 25), and generally requires that such transactions beaccounted for using a fair value-based method with the resulting compensationcost recognized over the period that the employee is required to provideservice in order to receive their compensation. The Company adopted SFAS 123R as of January 1, 2006 utilizing the modifiedprospective application.  Under thismethod, the provisions of SFAS 123R are applied to new awards and to awardsmodified, repurchased or canceled after December 31, 2005 and to awardsoutstanding on December 31, 2005 for which the requisite service has not yetbeen rendered.  Prior to December 31,2005, the Company accounted for its stock options using the intrinsic valuemethod, as prescribed by APB 25, and accordingly, no expense for stock optionswas recorded in periods prior to December 31, 2005.

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

The reported net incomeand earnings per share for the period shown are presented below to reflect theimpact had the Company been required to recognize compensation expense based onSFAS 123R:

|                                                                                                                | ** ** | **Three Months**                | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                                     | ** ** | **Ended**                            | ** ** |
| ** **                                                                                                     | ** ** | **March 31,**                   | ** ** |
| ** **                                                                                                     | ** ** | **2005**                             | ** ** |
| ** **                                                                                                     | ** ** | **(Dollars in thousands)** | ** ** |
|                                                                                                           |       |                                 |       |
| Reported net income                                                                                            |       | $                                    | 822        |   |
| Deduct: Toal  share-based compensation expense determined using fair value method, net of  related tax effects |       | (36                                  | )          |
|                                                                                                           |       | 786                                  |       |
|                                                                                                           |       |                                 |       |
| Basic earnings per  share:                                                                                     |       |                                 |       |
| As  reported                                                                                                   |       | $                                    | 0.22       |   |
| Pro  forma                                                                                                     |       | $                                    | 0.21       |   |
|                                                                                                           |       |                                 |       |
| Diluted earnings per  share:                                                                                   |       |                                 |       |
| As  reported                                                                                                   |       | $                                    | 0.14       |   |
| Pro  forma                                                                                                     |       | $                                    | 0.13       |   |

 

14

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The estimated per shareweighted average fair value of options granted in the three months ended March31, 2006 and 2005 was $6.49 and $8.60, respectively.  The total intrinsic value of optionsexercised during the three months ended March 31, 2006 was $224,000 and thetotal fair value of shares vested during this period was $99,000.  As of March 31, 2006, total unrecognizedcompensation cost related to stock options issued but unvested was $420,000that will be recognized through 2008.

Under the fair valuemethod, stock option compensation expense is measured on the date of grantusing an option-pricing model.  Uponadoption of SFAS 123R, the fair values of the stock options were estimatedusing a lattice option pricing model. Previously, the fair values of stock options were estimated using theBlack-Scholes option-pricing model.  Dueto longer contractual terms of the Company’s stock options than traded options,suboptimal exercise patterns and risk-free interest rates and dividend ratesthat may be expected to differ over the option term from the grant date, thelattice option pricing model better reflects the substantive characteristics ofthe Company’s stock options.  The effectof the change to the lattice option pricing model did not have a materialimpact on the current period.

The lattice optionpricing models require certain assumptions. For the three months ended March 31, 2006, the expected volatilityassumption of 32% is based upon the weekly historical volatility of the Company’sstock price for the period January 1, 2000 through December 31, 2005 using ablend of the unweighted standard deviation of closing price with a weightedmean reversion formula.  The risk-freeinterest rate assumption ranged from 4.46% to 4.50% for the expected term ofthe share options and is based upon the U.S. Treasury implied forward yieldcurve at the time of the grant.  Thedividend yield assumption ranged from 0 to 2.5% during the expected term of theoptions and is based upon the Company’s capital planning model.  The assumptions used with the Black-Sholesoption pricing model, for the three months ended March 31, 2005, are asfollows: expected volatility 43%; expected term 10 years; risk-free interestrate 4.50%; and dividend yield 0%.

NOTE 10—COMPREHENSIVE INCOME (LOSS)

Comprehensive income(loss) is the change in equity during a period from transactions and otherevents and circumstances from nonowner sources. The accumulated balance of other comprehensive income (loss) is requiredto be displayed separately from retained earnings in the consolidated balancesheet.  Total comprehensive income (loss)was as follows:

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|                                                                                     | ** ** | **Three Months ended March 31,** | ** ** |
|-------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                          | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| ** **                                                                          | ** ** | **(Dollars in thousands)**                 | ** ** |
|                                                                                |       |                                                 |       |   |   |
| Net income                                                                          |       | $                                                    | 1,056      |   | $ | 822 |   |
|                                                                                |       |                                                 |       |   |   |
| Other comprehensive  income (loss) before tax, and unrealized losses on securities: |       |                                                 |       |   |   |
| Unrealized  gain (loss) on interest rate swaps used in cash flow hedges             |       | (504                                                 | )          | (1,083 | ) |
| Unrealized  gain (loss) on interest rate floors used in cash flow hedges            |       | (224                                                 | )          | — |   |
| Unrealized  gain (loss) on securities available for sale                            |       | (796                                                 | )          | (425 | ) |
| Other  comprehensive income (loss), before tax                                      |       | (1,524                                               | )          | (1,508 | ) |
|                                                                                |       |                                                 |       |   |   |
| Income tax benefit  (expense) related to items of other comprehensive income        |       | 444                                                  |       | 699 |   |
| Other  comprehensive income (loss)                                                  |       | (1,080                                               | )          | (809 | ) |
| Total  comprehensive income                                                         |       | $                                                    | (24        | ) | $ | 13 |   |

 

NOTE 11—DERIVATIVE FINANCIAL INSTRUMENTS

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

Derivatives areaccounted for according to SFAS No. 133, Accounting for Derivative Instrumentsand Hedging Activities, as amended. This standard requires that all derivativeinstruments be recognized in the financial statements and measured at fairvalue regardless of the purpose or intent for holding them.  Some derivatives have been designated fairvalue hedges and cash flow hedges.  Toqualify for hedge accounting, the details of the hedging relationship must beformally documented at inception of the arrangement, including the riskmanagement objective, hedging strategy, hedged item, specific risks that arebeing hedged, the derivative instrument and how effectiveness is beingassessed.  The derivative must be highlyeffective in offsetting either changes in fair value or cash flows, asappropriate, for the risk being hedged. Effectiveness is evaluated on a retrospective and prospective basis. Ifa hedge relationship becomes ineffective, it no longer qualifies as a hedge.Any excess gains or losses attributable to such ineffectiveness, as well assubsequent changes in the fair value of the derivative, are recognized inearnings.

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The following is asummary of our risk management strategies and the effect of these strategies onthe consolidated financial statements.
|                        | ** ** | **March 31, 2006**         | ** ** | **December 31, 2005** | ** ** |
|------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **             | ** ** | **Notional  Amount**                 | ** ** | **Fair Value**             | ** ** | **Notional  Amount** | ** ** | **Fair Value** | ** ** |
| ** **             | ** ** | **(Dollars in thousands)** | ** ** |
| Fair value hedges:     |       |                                 |       |                            |       |   |   |   |   |
| Interest rate  swaps   |       | $                                    | 60,000     |                            | $          | (75 | ) | $ | 30,000 |   | $ | (41 | ) |
|                   |       |                                 |       |                            |       |   |   |   |   |
| Cash flow hedges:      |       |                                 |       |                            |       |   |   |   |   |
| Interest rate  swaps   |       | $                                    | 50,000     |                            | $          | (1,537 | ) | $ | 50,000 |   | $ | (1,034 | ) |
| Interest rate  floors  |       | $                                    | 50,000     |                            | $          | 45 |   | $ | 50,000 |   | $ | 268 |   |
|                   |       |                                 |       |                            |       |   |   |   |   |
| Non-hedge derivatives: |       |                                 |       |                            |       |   |   |   |   |
| Interest rate  swaps   |       | $                                    | 15,000     |                            | $          | (1,023 | ) | $ | 15,000 |   | $ | (575 | ) |
| Interest rate floors   |       | 150,000                              |       | —                          |       | 150,000 |   | — |   |

 

Fair value hedges arehedges that minimize the risk of changes in the fair values of assets,liabilities and certain types of firm commitments.  The Company uses interest rate swaps to hedgethe change in fair value of its brokered certificates of deposit.  The interest rate swaps result in the Companypaying or receiving the difference between the fixed and floating rates atspecified intervals calculated on the notional amounts.  The differential paid or received on suchinterest rate swaps are recognized as an adjustment to interest expense.  The net change in fair value of thederivatives and the hedged items is reported in earnings.  The fair value hedges are highly effectiveand therefore no ineffectiveness was recognized in current earnings related tothis swap.

Cash flow hedges arehedges that use simple derivatives to offset the variability of expected futurecash flows.  The Company’s cash flowhedges include certain interest rate swaps and interest rate floors used tomanage the interest rate risk associated with its significant volume ofadjustable rate loans.  At March 31,2006, a loss of $1.5 million was recorded in accumulated other comprehensiveincome and no ineffectiveness was recorded to earnings for the three monthsended March 31, 2006 related to these interest rate swaps.  At March 31, 2005, a loss of $224,000 wasrecorded in accumulated other comprehensive income related to the interest ratefloors and no ineffectiveness was recorded to earnings for the three monthsended March 31, 2005 related to these interest rate floors.

Non-hedge derivativesare interest rate floors and interest rate swaps that do not meet the strictcriteria for hedge accounting treatment. We use derivatives to hedge exposures when it makes economic sense to doso, including circumstances in which the hedging relationship does not qualifyfor hedge accounting.  Derivatives notdesignated as hedges are marked to

17

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market through earnings. The Company has enteredinto an interest rate swap agreement to pay an adjustable rate and receive afixed rate with terms that mirror its junior subordinated debentures.  At inception of this swap, the Companydesignated this swap as a fair value hedge of its junior subordinateddebentures and established the “short-cut” method of documenting the hedgeeffectiveness.  As a result of subsequenttechnical interpretations of the “short-cut” hedge accounting rules, theCompany has treated this swap as a non-hedge derivative and restated itsfinancial statements since inception of the transaction accordingly.  The effect of the non-hedge derivativetreatment is to reflect the change in fair value of the swap in current incomeas a trading gain or loss.  There was a$448,000 and $204,000 trading loss recorded for the three months ended March31, 2006 and 2005 reflecting the change in market value of this swap. During2005, the Company purchased a one year interest rate floor to help protect itsnet interest income in the event of a rapid decline in interest rates andpermit it to execute other strategies to protect against declining interestrates over time.  There was no charge toearnings during the first quarter 2006 as the floor has previously written downto zero.

NOTE 12—RECLASSIFICATIONS

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

NOTE 17—SUBSEQUENT EVENT

*Agreementand Plan of Merger*

On June 15, 2006,National Mercantile entered into an Agreement and Plan of Merger (the “MergerAgreement”) with FCB Bancorp, a California corporation (“FCB”), and FirstCalifornia Financial Group, Inc. (“FCFG”), a new Delaware corporationformed by National Mercantile for the purpose of the merger transactions.  The Merger Agreement provides for thereincorporation merger of National Mercantile into FCFG immediately followed bythe merger of FCB into FCFG (together, the “Mergers”).

Consummation of theMergers is subject to a number of closing conditions, including approval by theshareholders of both National Mercantile and FCB and regulatory approval.

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***Item2.******          MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS***

National MercantileBancorp (“National Mercantile” on a parent-only basis, and the “Company” on aconsolidated basis) is the holding company for two subsidiary banks, MercantileNational Bank (“Mercantile”) and South Bay Bank, N.A. (“South Bay”)(collectively, “the Banks”).  NationalMercantile’s principal assets are the capital stock of Mercantile and SouthBay.  The per share data reflects thefive-for-four stock split paid April 14, 2006 to shareholders of record March31, 2006 as well as the conversion of the Series A Preferred stock to commonstock in June 2005.

**RESTATEMENT**

The Company has restatedits consolidated financial statements for the years ended December 31,2003, 2004 and 2005 and as of March 31, 2006 and for the three months thenended. This restatement corrected errors related to the Company’s derivativeaccounting under Statement of Financial Accounting Standards No. 133,Accounting for Derivative Instruments and Hedging Activities (“SFAS No. 133”).

In 2003, the Companyentered into an interest rate swap agreement in connection with the trust preferredsecurities related to the Company’s junior subordinated deferrable interestdebentures (Trust Preferred Swap) that was accounted for as a fair value hedgeunder SFAS No. 133. The Company elected an abbreviated method (the “short-cut”method) of documenting the effectiveness of the swap as a hedge, which allowedthe Company to assume no ineffectiveness in this transaction. As a result oflater technical interpretations of SFAS 133, the Company subsequently concludedthat the Trust Preferred Swap did not qualify for this method in priorperiods.  The presence of an interestdeferral feature in the interest rate swap was determined, in retrospect, tohave caused the interest rate swap to not have a fair value of zero atinception, which is required under SFAS 133 to qualify for short-cut hedgeaccounting treatment.  Hedge accountingunder SFAS No. 133 for this swap transaction is not allowedretrospectively because the hedge documentation required for the long-haulmethod was not in place at the inception of the hedge. Eliminating theapplication of fair value hedge accounting reverses the fair value adjustmentsthat were made to the hedged item, the debt, as an adjustment to the par amountof the Trust Preferred debt. This reversal of fair value hedge accountingalso results in reclassification of swap net settlements from interest expenseto noninterest income as well as recording of swap mark-to-market adjustmentsin trading gains (losses) on economic derivatives.

The following tableshows the statement of operations as originally reported and as restated, withthe adjustments, for the three months ended March 31, 2006:

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|                                                         | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                              | ** ** | **March 31, 2006**     | ** ** |
| ** **                                              | ** ** | **As  Originally  Reported**     | ** ** | **Restated** | ** ** |
|                                                    |       |                             |       |   |   |
| Net interest  income before provision for credit losses |       | $                                | 5,759      |   | $ | 5,759 |   |
| Net cash  settlement of interest rate swap derivative   |       | —                           |       | (43 | ) |
| Total net interest income                               |       | 5,759                            |       | 5,716 |   |
| Provision  (benefit) for credit losses                  |       | 32                               |       | 32 |   |
| Net interest income after provision for credit  losses  |       | 5,727                            |       | 5,684 |   |
| Total other  operating income                           |       | 322                              |       | 322 |   |
| Net cash settlement of interest rate swap derivative    |       | —                           |       | 43 |   |
| Change in fair value of interest rate swap  derivative  |       | —                           |       | (448 | ) |
| Total non-interest income                               |       | 322                              |       | (83 | ) |
| Total other  operating expenses                         |       | 3,732                            |       | 3,732 |   |
| Income before taxes                                     |       | 2,317                            |       | 1,869 |   |
| Income tax  expense                                     |       | 999                              |       | 999 |   |
| Income tax effect on restatement                        |       | —                           |       | (186 | ) |
| Total income tax expense                                |       | 999                              |       | 813 |   |
| Net income                                              |       | $                                | 1,318      |   | $ | 1,056 |   |
|                                                    |       |                             |       |   |   |
| Net income per  share – Basic                      |       | $                                | 0.24       |   | $ | 0.19 |   |
| Net income per share –  Diluted                    |       | $                                | 0.22       |   | $ | 0.18 |   |

 

**RESULTSOF OPERATIONS OVERVIEW**

We recorded net incomeof $1.1 million, or $0.19 basic earnings per share and $0.18 diluted earningsper share, for the three months ended March 31, 2006 compared to net income of$822,000, or $0.22 basic earnings per share and $0.14 diluted earnings pershare, for the same period of 2005.  Theincrease in net income for the first quarter of 2006 was primarily due to a$971,000 increase in net interest income before the provision for credit lossesresulting from increases in the prime rate lending index, a greater volume ofinterest earning assets, particularly higher-yielding loans receivable andsecurities available-for-sale, and a favorable change in earning asset andfunding liability composition.  Thisincrease in net interest income for the first quarter of 2005 was partiallyoffset by a $246,000 increase in noninterest expense.  The Company adopted Statement of FinancialAccounting Standards No. 123R, Stock-Based Payments (SFAS 123R), January 1,2006 resulting in the recognition of compensation expense for unvested stockoptions and an after-tax charge of $85,000 to earnings.

Return on average assetsduring the first quarter of 2006 was 0.92% compared to 0.83% during the firstquarter of 2005.  Return on averageequity during the first quarter of 2006 was 10.68% compared to 9.31% during thefirst quarter of 2005.

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NET INTEREST INCOME

Net interest incomeincreased $971,000 to $5.7 million during the first quarter of 2006 compared tofirst quarter 2005 due to a $2.2 million increase in interest income offset bya $1.2 million increase in interest expense.

Loan interest incomeincreased $1.6 million due to $34.0 million greater average volume of loansreceivable and a 118 basis point increase in yield, resulting primarily fromincreases in the prime rate lending index. During the second half of 2004, the Federal Reserve Bank increasedinterest rates 125 basis points on five occasions after a prolonged period ofaccommodative monetary policy in response to signs of stronger economicactivity and perceived higher inflation risk. During 2005, the Federal Reserve Bank increased interest rates 200 basispoints on eight occasions and, continuing into the first quarter of 2006,another 50 basis points on two occasions. Approximately 75% of our $353.5 million loans receivable at March 31,2006, have adjustable interest rates; consequently, rising interest ratespositively affect interest income. Conversely, declining interest rate environments have the potential tonegatively impact our net interest income. In order to reduce the negative impact in the event of a decline in theprime rate lending index, we have entered into interest rate swaps, in which weexchanged an adjustable rate interest payment based on the prime rate lendingindex for a fixed rate payment on an aggregate notional amount of $50.0million.  The higher yields earned on ourloans receivable during the first quarter of 2006 were partially offset by therising cost of the interest rate swaps.

Interest income fromsecurities available-for-sale increased $625,000 during the first quarter of2006 compared to the same period of 2005 due to $37.8 million greater averagevolume and a 159 basis point increase in yield. During the third and fourth quarter of 2005 and continuing into 2006, wehave steadily added newly purchased securities to our investment portfolio aspart of a strategy to further reduce the exposure of net interest income to adeclining interest rate environment.  Theadditions to securities have been instruments that we expect to have limitedprepayment of principal in the event of declining interest rates (and mutedterm extension in rising interest rates). These investments, as well as loans receivable, have been largelyfinanced with adjustable rate wholesale funds that will decline in cost in afalling interest rate environment.  Themore recently purchased securities, in a period of higher interest rates, andthe maturity of lower yielding securities in the portfolio, resulted in anincrease in the portfolio yield.

Overall,interest-earning assets were $64.0 million greater during 2006 period than 2005while the higher interest rates and favorable change in composition tohigher-yielding assets resulted in a 112 basis point increase in weightedaverage yield on interest-earning assets.

21

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Interest expenseincreased $1.2 million during the first quarter of 2006 compared to the sameperiod in 2005 due to a $63.5 million increase in average interest-bearingliabilities and a 128 basis point increase in the weighted average cost ofinterest-bearing liabilities.  Interestexpense on deposits increased $1.0 million due to a 133 basis point rise inweighted average cost of interest-bearing deposits in addition to $46.0 milliongreater average volume than 2004.  Timecertificates of deposit $100,000 and over averaged $41.0 million greater duringthe 2006 period than 2005 due to an increased volume of brokered certificatesof deposit (“Brokered CDs”).  The volumeof money market and savings deposits increased $7.8 million during the firstquarter of 2006 compared to first quarter of 2005 while time certificates ofdeposit under $100,000 declined $3.6 million.

During the risinginterest rate environment experienced during the past six quarters, westrategically elected to only moderately increase transaction deposit rates andto fund asset growth, and runoff of these deposits, with Brokered CDs.  Although this type of funding is typicallyhigher costing and exhibits higher interest rate sensitivity, the Brokered CDsfacilitate our liquidity and interest rate risk management that we utilize toreduce our net interest income exposure to possible declining interestrates.  The greater interest expense onthe incremental Brokered CDs needed to fund asset growth is less than theimpact of increasing rates on the significantly greater volume of transactionaccounts.  As market interest ratescontinue to rise, the cost of our deposits has been increasing more rapidly dueto more frequent exceptions to our posted interest rates granted to depositorsin order to prevent deposit withdrawals.

The cost of timecertificates of deposit $100,000 and over increased 175 basis points during thefirst quarter of 2006 compared to first quarter 2005.  The cost of money market and savings depositsincreased 127 basis points while the cost of interest-bearing demand depositsand time certificates of deposit under $100,000 increased 11 basis points and88 basis points, respectively.

The volume of other borrowingsaveraged $20.3 million and $15.1 million during the first quarter of 2006 and2005, respectively.  We continue toemploy a liquidity strategy of maintaining relatively low levels of short-termassets and utilizing Federal Home Loan Bank overnight advances, against pledgedloans and securities, to fund asset and deposit fluctuations.  Minimizing short-term assets and increasingshort-term liabilities furthers the interest rate risk management of our assetsensitive balance sheet.  The cost ofother borrowings was 4.48% and 2.52% for 2005 and 2004 periods, respectively,representing an increase of 196 basis points for the first quarter of 2006.

22

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The restatement eliminating hedge accountingtreatment for the interest rate swap on our junior subordinated debenturesresulted in a reclassification of the interest rate swap net settlement paymentfrom interest expense to other operating income increasing interest expense$43,000 and $116,000 for the three months ended March 31, 2006 and 2005.

Securities sold underagreement to repurchase (“Repurchase Agreements”) averaged $12.3 million duringthe first quarter of 2006 with a cost of 4.77%. The Repurchase Agreements, total $15.0 million with an adjustableinterest rate based upon the LIBOR index and have an embedded floor with astrike rate of 4.0% maturing in January 2008, further our interest rate riskmanagement objectives.  In the event thatthe LIBOR index declines below the strike rate, the cost of the RepurchaseAgreements will decline at double the difference between the LIBOR index andthe strike rate.  We had no RepurchaseAgreements during 2005.

Noninterest-bearingdemand deposits averaged $113.4 million during the first quarter 2006 or $8.0million less than during the same quarter in 2005.  Rising interest rates increase depositors’opportunity cost of noninterest-bearing deposits and their sensitivity tomaintaining such balances, resulting in the redeployment of their funds intohigher yielding deposits and alternative investments outside the Banks.

The net yield oninterest earning assets (net interest margin) was 5.45% during the firstquarter in 2006 compared to 5.32% during the first quarter in 2005, while thenet interest spread was 4.54% and 4.70%, respectively.  The net interest margin and net interestspread during the first quarter of 2006 have declined from recent quarterslargely due to the securities leverage strategy – intermediate-term securitypurchases financed with short-term wholesale funds – executed to reduce ourbalance sheet asset sensitivity.  Also,the first quarter of 2006 experienced a “flat yield curve” in which short-termrates have risen to the level of long-term interest rates.  A preponderance of our funding sources arecorrelated to the short-term rates.

The following tablepresents the components of net interest income for the three months ended March31, 2006 and 2005.

23

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**AverageBalance Sheet and**

**Analysisof Net Interest Income**
| ** **                                                                                      | ** ** | **Three Months ended**     | ** ** |
|-------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                      | ** ** | **March 31, 2006**         | ** ** | **March 31, 2005** | ** ** |
| ** **                                                                                      | ** ** | ** **                           | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                                                                                      | ** ** | ** **                           | ** ** | **Interest** | ** ** | **Average** | ** ** | ** ** | ** ** | **Interest** | ** ** | **Average** | ** ** |
| ** **                                                                                      | ** ** | **Average**                          | ** ** | **Income/** | ** ** | **Yield/** | ** ** | **Average** | ** ** | **Income/** | ** ** | **Yield/** | ** ** |
| ** **                                                                                      | ** ** | **Amount**                           | ** ** | **Expense** | ** ** | **Rate** | ** ** | **Amount** | ** ** | **Expense** | ** ** | **Rate** | ** ** |
| ** **                                                                                      | ** ** | **(Dollars in thousands)** | ** ** |
| Assets:                                                                                         |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Federal funds sold and  securities                                                              |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Federal funds sold                                                                              |       | $                                    | 443        |   | 5 |   | 4.58 | % | $ | 1,667 |   | 10 |   | 2.43 | % |
| Due from banks-interest  bearing                                                                |       | 2,000                                |       | 21 |   | 4.26 | % | 7,660 |   | 16 |   | 0.85 | % |
| Securities  available-for-sale                                                                  |       | 77,729                               |       | 959 |   | 4.94 | % | 39,909 |   | 334 |   | 3.35 | % |
| Securities  held-to-maturity                                                                    |       | 2,546                                |       | 26 |   | 4.08 | % | 3,415 |   | 34 |   | 3.98 | % |
| Loans receivable (1)  (2)                                                                       |       | 342,737                              |       | 7,040 |   | 8.33 | % | 308,766 |   | 5,443 |   | 7.15 | % |
| Total  interest earning assets                                                                  |       | 425,455                              |       | 8,051 |   | 7.67 | % | 361,417 |   | 5,837 |   | 6.55 | % |
|                                                                                            |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest earning  assets:                                                                    |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Cash  and due from banks - demand                                                               |       | 15,020                               |       |   |   |   |   | 19,135 |   |   |   |   |   |
| Other  assets                                                                                   |       | 23,635                               |       |   |   |   |   | 20,569 |   |   |   |   |   |
| Allowance  for credit losses and net unrealized gain on sales of securities  available-for-sale |       | (5,229                               | )          |   |   |   |   | (4,066 | ) |   |   |   |   |
| Total assets                                                                                    |       | $                                    | 458,881    |   |   |   |   |   | $ | 397,055 |   |   |   |   |   |
|                                                                                            |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Liabilities and  shareholders’ equity:                                                     |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  deposits:                                                                     |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Demand                                                                                          |       | $                                    | 32,909     |   | 42 |   | 0.52 | % | $ | 32,036 |   | 32 |   | 0.41 | % |
| Money  market and savings                                                                       |       | 110,886                              |       | 584 |   | 2.14 | % | 103,132 |   | 220 |   | 0.87 | % |
| Time  certificates of deposit:                                                                  |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| $100,000  or more                                                                               |       | 86,395                               |       | 768 |   | 3.61 | % | 45,433 |   | 208 |   | 1.86 | % |
| Under  $100,000                                                                                 |       | 24,217                               |       | 176 |   | 2.95 | % | 27,767 |   | 142 |   | 2.07 | % |
| Total  time certificates of deposit                                                             |       | 110,612                              |       | 944 |   | 3.46 | % | 73,200 |   | 350 |   | 1.94 | % |
| Total  interest-bearing deposits                                                                |       | 254,407                              |       | 1,570 |   | 2.50 | % | 208,368 |   | 602 |   | 1.17 | % |
| Other borrowings                                                                                |       | 20,283                               |       | 224 |   | 4.48 | % | 15,139 |   | 94 |   | 2.52 | % |
| Junior subordinated  debentures                                                                 |       | 15,464                               |       | 396 |   | 10.39 | % | 15,464 |   | 396 |   | 10.39 | % |
| Federal funds purchased  and securities sold under agreements to repurchase                     |       | 12,333                               |       | 145 |   | 4.77 | % | — |   | — |   | — |   |
| Total  interest-bearing liabilities                                                             |       | 302,487                              |       | 2,335 |   | 3.13 | % | 238,971 |   | 1,092 |   | 1.85 | % |
|                                                                                            |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  liabilities:                                                               |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  demand deposits                                                            |       | 113,413                              |       |   |   |   |   | 121,408 |   |   |   |   |   |
| Other  liabilities                                                                              |       | 3,417                                |       |   |   |   |   | 1,349 |   |   |   |   |   |
| Shareholders’ equity                                                                       |       | 39,564                               |       |   |   |   |   | 35,327 |   |   |   |   |   |
| Total liabilities and  shareholders’ equity                                                |       | $                                    | 458,881    |   |   |   |   |   | $ | 397,055 |   |   |   |   |   |
|                                                                                            |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income  (spread)                                                                   |       |                                 |       | $ | 5,716 |   | 4.54 | % |   |   | $ | 4,745 |   | 4.70 | % |
|                                                                                            |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Net  yield on earning assets (2)                                                                |       |                                 |       |   |   | 5.45 | % |   |   |   |   | 5.32 | % |
|                                                                                                 |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

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

24

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Thefollowing table sets forth, for the periods indicated, the changes in interestearned and interest paid resulting from changes in volume and changes inrates.  Average balances in allcategories in each reported period were used in the volume computations.  Average yields and rates in each reportedperiod were used in rate computations.

|                                                                             | ** ** | **Three Months ended March 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                  | ** ** | **2006 vs 2005**                           | ** ** |
| ** **                                                                  | ** ** | ** **                                           | ** ** | **Net** | ** ** |
| ** **                                                                  | ** ** | **Increase (decrease) due to:**       | ** ** | **Increase** | ** ** |
| ** **                                                                  | ** ** | **Volume**                                           | ** ** | **Rate** | ** ** | **(Decrease)** | ** ** |
| ** **                                                                  | ** ** | **(Dollars in thousands)**                 | ** ** |
| Interest Income:                                                            |       |                                                 |       |   |   |   |   |
| Federal funds sold                                                          |       | $                                                    | (7         | ) | $ | 2 |   | $ | (5 | ) |
| Interest-bearing deposits with other financial  institutions                |       | (12                                                  | )          | 17 |   | 5 |   |
| Securities available-for-sale                                               |       | 317                                                  |       | 308 |   | 625 |   |
| Securities held-to-maturity                                                 |       | (9                                                   | )          | 1 |   | (8 | ) |
| Loans receivable (2)                                                        |       | 599                                                  |       | 998 |   | 1,597 |   |
| Total interest-earning assets                                               |       | 888                                                  |       | 1,326 |   | 2,214 |   |
|                                                                        |       |                                                 |       |   |   |   |   |
| Interest Expense:                                                           |       |                                                 |       |   |   |   |   |
| Interest-bearing deposits:                                                  |       |                                                 |       |   |   |   |   |
| Demand                                                                      |       | $                                                    | 1          |   | $ | 9 |   | $ | 10 |   |
| Money market and savings                                                    |       | 17                                                   |       | 347 |   | 364 |   |
| Time certificates of deposit:                                               |       |                                                 |       |   |   |   |   |
| $100,000 or more                                                            |       | 188                                                  |       | 372 |   | 560 |   |
| Under $100,000                                                              |       | (18                                                  | )          | 52 |   | 34 |   |
| Total time certificates of deposit                                          |       | 170                                                  |       | 424 |   | 594 |   |
| Total interest-bearing deposits                                             |       | 188                                                  |       | 780 |   | 968 |   |
| Other borrowings                                                            |       | 32                                                   |       | 98 |   | 130 |   |
| Junior subordinated debentures                                              |       | —                                               |       | — |   | 0 |   |
| Federal funds purchased and securities sold under  agreements to repurchase |       | 145                                                  |       | — |   | 145 |   |
| Total interest-bearing liabilities                                          |       | 365                                                  |       | 878 |   | 1,243 |   |
|                                                                        |       |                                                 |       |   |   |   |   |
| Net interest income                                                         |       | $                                                    | 523        |   | $ | 448 |   | $ | 971 |   |

 

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(1)     The change in interest income or interestexpense that is attributable to both changes in average balance, average rateand days in the quarter has been allocated to the changes due to (i) averagebalance and (ii) average rate in proportion to the rel

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

PROVISION FOR CREDIT LOSSES

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

25

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OTHER OPERATING INCOME

Other operating incomewas an $83,000 loss for the first quarter of 2006 compared to $234,000 for thesame period in 2005.  The 2006 periodincluded a $448,000 trading loss on non-hedge derivatives compared to a$204,000 trading loss for the first quarter 2005.  The trading losses reflect the restatement inwhich hedge accounting treatment is not applied to an interest rate swap, butrather its change in fair value is recognized in current income.  Deposit-related fees decreased in the 2006period due to higher compensating balance rates and changes in feestructure.  This decline was offset by a$48,000 gain on the sale of other real estate owned acquired throughforeclosure and an increase in international services fees.

OTHEROPERATING EXPENSES

Otheroperating expenses increased to $3.7 million for the three months ended March31, 2006 compared to $3.5 million for the same period of 2005. Significantvariances within operating expenses were: (i) salaries and related benefitsexpense increased $251,000 or 13.7% due to the adoption of SFAS 123R requiringstock options to be expensed, the addition of business development staff andincreased incentive expense; (ii) legal services expense decreased $74,000 or50.0% primarily due to fewer problem assets and the decline in related legalactivity; and (iii) other professional services expense increased $50,000 or19.7% due to increased costs for audit services, recruiting fees and directors’fees.

***BALANCESHEET ANALYSIS***

INVESTMENTSECURITIES

The following comparative period-end table sets forthcertain information concerning the estimated fair values and unrealized gainsand losses of securities available-for-sale and securities held-to-maturity.

26

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**EstimatedFair Values of and Unrealized**

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

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

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

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

 

27

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As of March31, 2006, we did not hold securities of any issuer, other than U.S.government-chartered agencies, the aggregate book value of which exceeded 10%of our shareholders’ equity.  At March31, 2006 and December 31, 2005, we had no securities determined to beother-than-temporarily impaired.

LOANPORTFOLIO

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

**LoanPortfolio Composition**

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

 

Loans receivableincreased $14.9 million to $353.5 million at March 31, 2006 compared to $338.6million at December 31, 2005 primarily due to increased funding of commercialreal estate loans, secured and unsecured commercial loans and constructionloans.  We have increased funding ofintermediate-term fixed rate commercial real estate loans as part of ourinterest rate risk management strategy.

NONPERFORMING ASSETS

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

28

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

 

During the first quarterof 2006, we sold other real estate owned recording a $48,000 gain on sale.  A single secured commercial loan was onnonaccrual status due to borrower financial weakness and uncertaintysurrounding collateral value.  The loanwas originated as part of a settlement of a legal dispute and is current by wayof advances from an interest reserve, typical for this type of financing.  The borrower’s ability to repay our loan ishighly dependent upon its success in marketing certain distribution rights.

ALLOWANCE FOR CREDIT LOSSES

The adequacy of theallowance for credit losses is determined through periodic analysis of the loanportfolio.  This analysis includes asystematic and detailed review of the classification and categorization ofproblem loans; an assessment of the overall quality and collectibility of theportfolio; and consideration of the loan loss experience, trends in problemloans, concentrations of credit risk, as well as current economic conditions(particularly Southern California). Management performs a periodic risk and credit analysis, the results ofwhich are reported to the Board of Directors.

We charged off $1,000 ofloans during the first quarter of 2006, compared to $6,000 of loans charged offduring the first quarter of 2005.  Therewere no recoveries of loans previously charged off during the first quarter of2006, respectively, compared to $3,000 during the first quarter of 2005.  Pursuant to our evaluation of the allowancefor credit losses at March 31, 2006, we recorded a provision for credit lossesof $32,000 for the first quarter 2006.

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

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the loan portfolio and realization of collateralupon a default. Accordingly, no assurance can be given that the Company will notsustain loan losses materially in excess of the allowance for credit losses. Inaddition, the Office of the Comptroller of the Currency, as an integral part ofits examination process, periodically reviews the allowance for credit lossesand could require additional provisions for credit losses.

DEPOSITS

Total deposits were$405.4 million and $363.2 million at March 31, 2006 and December 31, 2005,respectively.  Noninterest-bearing demanddeposits increased to $122.6 million at March 31, 2006 compared to $115.9million at December 31, 2005.  Ournoninterest-bearing demand deposits experience significant variability andseasonality due to the nature of our depositors’ businesses and the cash needsof our business customers for quarterly tax payments and ownerdistributions.  Noninterest-bearingdemand deposits declined significantly at December 31, 2005 from the fourthquarter average of $122.8 million; thus the increase at March 31, 2006reflected a normalization following this year-end variability.  Money market deposits and savings depositswere $91.9 million and $26.3 million, respectively, at March 31, 2006 comparedto $76.3 million and $28.2 million, respectively, at December 31, 2005.  Interest-bearing demand deposits, which forthe most part are limited to individuals, decreased to $31.7 million at March31, 2006 from $36.0 million at December 31, 2005.  Interest-bearing demand deposits increasedsignificantly at December 31, 2005 from the fourth quarter average of $32.6million, thus the decline at March 31, 2006 reflected a normalization followingthe year-end variability.  Timecertificates of deposit increased to $132.8 million at March 31, 2006 from$106.7 million at December 31, 2005 due to an increase in brokereddeposits.  We had $60 million in brokeredtime certificates of deposit at March 31, 2006 compared to $37.5 million atDecember 31, 2005.

Additionally, althoughwe have priced our retail certificates of deposit to encourage runoff duringthe past several years, in the rising rate environment experienced during thepast 7 quarters, we have elected to only moderately increase rates on itsimmediately repriceable base of deposits – interest-bearing demand deposits,and savings and money market deposits – and price new time certificates of depositto generate growth.

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

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SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE

Securities sold underagreements to repurchased (“Repurchase Agreements”) totaled $15.0 million atMarch 31, 2006.  We entered into theRepurchase Agreements to further our liquidity and interest rate sensitivityobjectives.  The Repurchase Agreementsare adjustable rate and contain embedded interest rate floors that will resultin an exponential decline in cost in the event of a sustained decline ininterest rates.  The embedded interestrate floors are clearly and closely related to the economic characteristics andrisks of the underlying Repurchase Agreements and accordingly are not separatedand accounted for as derivative instruments. We had no repurchase agreements at December 31, 2005.

OTHER BORROWINGS

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

SHAREHOLDERS’ EQUITY

Shareholders’ equityincreased from $38.2 million at December 31, 2005 to $38.7 million at March 31,2006 due to the retained earnings for the three months ended March 31, 2006partially offset by a decrease in market value of interest rate swaps andsecurities available-for-sale.

***CAPITAL ADEQUACY REQUIREMENTS***

At March 31, 2006,National Mercantile and the Banks were in compliance with all applicableregulatory capital requirements and the Banks were “well capitalized” under thePrompt Corrective Action rules of the OCC. The following table sets forth the regulatory capital standards forwell-capitalized institutions, and the capital ratios for National Mercantileand the Banks, as of March 31, 2006 and December 31, 2005.

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**Regulatory Capital Information**

**of theNational Mercantile Bancorp and Banks**
|                                   | ** ** | **Minimum**          | ** ** | ** **      | ** ** | ** **         | ** ** | ** **            | ** ** |
|-----------------------------------|------------|----------------------|------------|-----------------|------------|--------------------|------------|-----------------------|------------|
| ** **                        | ** ** | **For Capital** | ** ** | **Well**        | ** ** | ** **         | ** ** | ** **            | ** ** |
| ** **                        | ** ** | **Adequacy**         | ** ** | **Capitalized** | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
| ** **                        | ** ** | **Purposes**         | ** ** | **Standards**   | ** ** | **2006**           | ** ** | **2005**              | ** ** |
| **National  Mercantile Bancorp:** |       |                 |       |            |       |               |       |                  |       |
| Tier 1 leverage                   |       | 4.00                 | %          | N/A             |       | 10.92              | %          | 10.74                 | %          |
| Tier 1  risk-based capital        |       | 4.00                 | %          | N/A             |       | 12.13              | %          | 11.98                 | %          |
| Total risk-based  capital         |       | 8.00                 | %          | N/A             |       | 13.89              | %          | 13.72                 | %          |
|                              |       |                 |       |            |       |               |       |                  |       |
| **Mercantile  National Bank:**    |       |                 |       |            |       |               |       |                  |       |
| Tier 1 leverage                   |       | 4.00                 | %          | 5.00            | %          | 10.47              | %          | 10.49                 | %          |
| Tier 1  risk-based capital        |       | 4.00                 | %          | 6.00            | %          | 12.88              | %          | 13.59                 | %          |
| Total risk-based  capital         |       | 8.00                 | %          | 10.00           | %          | 14.13              | %          | 14.84                 | %          |
|                              |       |                 |       |            |       |               |       |                  |       |
| **South  Bay Bank, NA:**          |       |                 |       |            |       |               |       |                  |       |
| Tier 1 leverage                   |       | 4.00                 | %          | 5.00            | %          | 8.98               | %          | 9.04                  | %          |
| Tier 1  risk-based capital        |       | 4.00                 | %          | 6.00            | %          | 9.32               | %          | 9.00                  | %          |
| Total risk-based  capital         |       | 8.00                 | %          | 10.00           | %          | 10.54              | %          | 10.22                 | %          |

 

***LIQUIDITY***

We manage our liquiditythrough a combination of core deposits, federal funds purchased, repurchaseagreements, collateralized borrowing lines, and a portfolio of securitiesavailable for sale.  Liquidity is alsoprovided by maturing investment securities and loans.

Ourcash and due from banks - demand was $15.2 million on March 31, 2006 comparedto $13.5 million on December 31, 2005. Due from banks-interest-bearing was $2.0 million at March 31, 2006 andDecember 31, 2005.  There was $2.8 millionin Federal funds sold at March 31, 2006 compared to $685,000 at December 31,2005.  Mercantile had $12.5 million andSouth Bay had $10.0 million in Federal funds borrowing lines with correspondentbanks as of March 31, 2006. Additionally, at March 31, 2006 we had $73.4 million remaining borrowingcapacity at the FHLB against pledged loans and securities.

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

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

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

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

Mercantile has anaccumulated deficit and does not anticipate having positive cumulative retainedearnings until 2008 at the current rate of earnings.  South Bay had cumulative retained earnings of$3.8 million as of March 31, 2006. Mercantile and South Bay may from time to time be permitted to makecapital distributions to National Mercantile with the consent of the OCC.  It is likely that such consent could not beobtained unless the distributing bank remained “well capitalized” followingsuch distribution. 

***ASSET LIABILITY MANAGEMENT***

We manage interest ratesensitivity by matching the repricing opportunities on our earning assets tothose on our funding liabilities. Various strategies are used to manage the repricing characteristics ofassets and liabilities to ensure that exposure to interest rate fluctuations islimited within guidelines of acceptable levels of risk-taking.  Hedging strategies, including the terms andpricing of loans and deposits, the use of derivative financial instruments (seeNote 10 of the Notes to the Consolidated Financial Statements) 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,

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including stress tests,to measure the impact of changes in interest rates on future earnings.  These static measurements do not reflect theresults of any projected activity and are best used as early indicators ofpotential interest rate exposures.

The Company’s interestrate sensitivity position during a period of moderate rising interest rates isexpected to have a positive impact on net interest income due to the Company’slarge base of noninterest-bearing deposits as well as interest rates paid onfunding liabilities typically change in smaller magnitude compared to changesin the yield of its substantial adjustable earning assets.  Since interest rates began increasing in June2004, the Company’s net interest income has in fact significantly increasedwith funding costs lagging the increase in earning asset yields.  This lag in funding costs could narrow futurenet interest margins in the event that rates paid on deposits begin rising morerapidly due to increased funding needs or competitive pressures.

In a period of decliningrates, such as the environment that was experienced during 2001 and 2002, thedecline is expected to have a negative effect on the Company’s net interestincome as changes in the rates of interest-bearing deposits historically havenot changed in similar magnitude to changes in market interest rates.  Additionally, in relatively low and declininginterest rate environments, the interest rates paid on funding liabilities maybegin to reach floors preventing further downward adjustments while rates onearning assets continue to adjust downward. To partially mitigate the negative effects of declining interest rateson its net interest margin, during the third quarter 2005 the Companyaccelerated its purchases of intermediate term investment securities which werepartly funded by short-term liabilities. Additionally, the Company has entered into interest rate swap agreementsand has purchased interest rate floors at various strike prices and terms thathave the effect of further reducing its exposure to declining interest rates.

# **FACTORSWHICH MAY AFFECT FUTURE OPERATING RESULTS**

The Company’s results ofoperations and financial condition are affected by many factors, including thefollowing:

**Risk from changes in interestrates.**

Thesuccess of the Company’s business depends, to a large extent, on its netinterest income.  Changes in marketinterest rates can affect net interest income by affecting the spread betweeninterest-earning assets and interest-bearing liabilities.  This may be due to the different maturitiesof interest-earning assets and interest-bearing liabilities, as well as anincrease in the general level of interest rates.  Changes in market interest rates also affect,among other things:

·                  The Company’sability to originate loans;

·                  The abilityof borrowers to make payments on their loans;

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

·                  The averagelife of interest-earning assets;

·                  The abilityto generate deposits instead of other available funding alternatives;

·                  The abilityto access the wholesale funding market; and

·                  The value ofour derivative financial instruments.

Interest rates arehighly sensitive to many factors, including governmental monetary policies,domestic and international economic and political conditions and other factorsbeyond the Company’s control.

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

The Company’s financialcondition depends significantly on the quality of its assets.  While its has developed and implementedunderwriting policies and procedures to guide management in the making ofloans, compliance with these policies and procedures in making loans does notguarantee repayment of the loans.  If thelevel of non-performing assets rises, the results of operations and financial conditionwill be affected.  A borrower’s abilityto pay its loan in accordance with its terms can be adversely affected by anumber of factors, such as a decrease in the borrower’s revenues and cash flowsdue to adverse changes in economic conditions or a decline in the demand forthe borrower’s products and/or services.

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

Allowancesfor credit losses are established against each segment of the loanportfolio.  At March 31, 2006, theallowance for credit losses equaled 1.29% of loans receivable and 1520% ofnonperforming loans.  Although managementbelieves that it has established adequate allowances for credit losses as ofMarch 31, 2006, the credit quality of the Company’s assets is affected by manyfactors beyond its control, including local and national economic conditions,and the possible existence of facts which are not currently known whichadversely affect the likelihood of repayment of various loans in the loanportfolio and realization of the collateral upon a default.  Accordingly, there is no assurance that theCompany will not sustain loan losses materially in excess of the allowance forcredit losses.  In addition, the Officeof the Comptroller of the Currency, as an integral part of its examination process,periodically reviews the allowance for credit losses and could requireadditional provisions for credit losses. Material future additions to the allowance for credit losses may also benecessary due to increases in the size and changes in the composition of theloan portfolio.  Increases in theprovisions for credit losses would adversely affect the Company’s results ofoperations.

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**Economicconditions may worsen.**

TheCompany’s business is strongly influenced by economic conditions in its marketarea (principally, the greater Los Angeles metropolitan area) as well asregional and national economic conditions and in its niche markets, includingthe entertainment industry in Southern California.  Should the economic condition in these areasworsen, the financial condition of its borrowers could weaken, which could leadto higher levels of loan defaults or a decline in the value of collateral forits loans.  In addition, an unfavorableeconomy could reduce the demand for its loans and other products and services.

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

At March 31, 2006, alarge majority of the loans outstanding were collateralized by real propertieslocated in California.  Because of thisconcentration in Southern California, the Company’s 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 the loans,together with any primary financing on the mortgaged properties, equal orexceed the value of the mortgaged properties, the Company could incur higherlosses on sales of properties collateralizing foreclosed loans.  In addition, California historically has beenvulnerable to certain natural disaster risks, such as earthquakes anderosion-caused mudslides, which are not typically covered by the standardhazard insurance policies maintained by borrowers.  Uninsured disasters may adversely impact theability to recover losses on properties affected by such disasters andadversely impact the Company’s results of operations.

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

There is intensecompetition in Southern California and elsewhere in the United States forbanking customers.  The Companyexperiences competition for deposits from many sources, including creditunions, insurance companies and money market and other mutual funds, as well asother commercial banks and savings institutions.  The Company competes for loans and depositsprimarily with other commercial banks, mortgage companies, commercial financecompanies and savings institutions.  Inrecent years out-of-state financial institutions have entered the Californiamarket, which has also increased competition. Many of the competitors have greater financial strength, marketingcapability and name recognition, and operate on a statewide or nationwidebasis.  In addition, recent developmentsin technology and mass marketing have permitted larger companies to marketloans more aggressively to small business customers.  Such advantages may give the competitorsopportunities to realize greater efficiencies and economies of scale than theCompany can.  There is no assurance thatthe Company will be able to compete effectively against its competition.

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**The Company’s business is heavily regulated.**

BothNational Mercantile as a bank holding company, and Mercantile and South Bay, asnational banks, are subject to significant governmental supervision andregulation, which is intended primarily for the protection of depositors.  Statutes and regulations affecting theCompany may be changed at any time, and the interpretation of these statutesand regulations by examining authorities also may change.  There is no assurance that future changes inapplicable statutes and regulations or in their interpretation will notadversely affect the Company’s business.

**Goodwill is evaluated annuallyand any impairment must be recorded as a charge to earnings**.

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

TheCompany has goodwill of $3.2 million in connection with the South Bayacquisition in December 2001.  During thefourth quarter of 2005, the required impairment tests of goodwill werecompleted.  The tests determined thatgoodwill was not considered impaired.  Noassurance can be given that goodwill will not become impaired in the future.

**The Company annually evaluateswhether the deferred tax asset will be realized and must establish a valuationallowance if necessary to reduce it to its realizable value.**

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

·                  Futureearnings are likely;

·                  Expectedfuture taxable income arising from the reversal of temporary differencesadequate to realize the tax asset

A valuation allowance may be established toreduce the deferred tax asset to its realizable value.  The determination of whether a valuationallowance is necessary involves considering the positive and negative factorsrelated 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 a valuation allowance to the deferred tax asset is necessary.  No such valuation allowance existed at March31, 2006.

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CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

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

**ITEM 3. CONTROLS AND 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.

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.

As a result of arecent interpretation on the “short cut” method of accounting for derivativesas hedges under of SFAS 133, the Company undertook additional review andtesting of its internal controls.  Afterinitial discussions with its auditors, the Audit Committee held a meeting onAugust 8, 2006 to review with management the potential impact of these matters.After completing further analysis, management recommended to the AuditCommittee, at a follow-up meeting held on August 14, 2006, that previouslyreported financial results be restated to eliminate hedge accounting for thederivative. The Audit Committee agreed with management’s recommendation.

In connection withthis amended Form 10-QSB, under the direction of our Chief Executive Officerand Chief Financial Officer, we reevaluated our disclosure controls andprocedures.  We considered the reasonswhy the restatement was necessary and whether the restatement resulted from amaterial weakness in our disclosure controls and procedures.  Our Chief Executive Officer and Chief FinancialOfficer determined that the restatement does not affect their conclusion thatour disclosure controls and procedures were effective as of March 31,2006.  Factors that led to thisdetermination included: (i) we had retained and received advice fromprofessional experts in the accounting for derivatives as hedges transactionsat the time of the transaction and in connection with subsequent financialreporting, including our Form 10-QSB for the quarter ended March 31, 2006; (ii)the accounting treatment previously used by us was consistent with industrypractice; (iii) our interpretation of the accounting rules under SFAS No. 133was reasonable; and (iv) management, and our Audit Committee, identified therecent interpretation on the “short cut” method of accounting for derivativesas hedges that resulted in the restatement of our financial statements.

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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**PARTII—OTHER INFORMATION**

***Item 1.******       LEGAL PROCEEDINGS***

None.

***Item2.******       UNREGISTEREDSALES OF EQUITY SECURITIES AND USE OF PROCEEDS***

None.

***Item 3.******       DEFAULTS UPON SENIORSECURITIES***

None.

***Item 4.******       SUBMISSION OF MATTERS TO AVOTE OF SECURITY HOLDERS***

None.

***Item5.******       OTHERINFORMATION***

None.

***Item6.******       EXHIBITS***

31.1 Certification of Scott A. Montgomery ondisclosure controls

31.2 Certification of David R. Brown on disclosurecontrols

32.1 Certification of Scott A. Montgomery pursuantto section 906 of the Sarbanes-Oxley Act of 2002

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

**SIGNATURES**

Pursuant to the requirementsof the Securities Exchange Act of 1934, the registrant has duly caused thisreport to be signed on its behalf by the undersigned thereunto duly authorized.
| ** ** | ** **           | **NATIONAL MERCANTILE BANCORP**                       | ** ** |
|------------|----------------------|-------------------------------------------------------|------------|
|       |                 | (Registrant)                                          |
|       |                 |                                                  |
| DATE:      | October 2, 2006 |                                                  |       | /s/   SCOTT  A. MONTGOMERY |   |
| ** ** |                 | **Scott A. Montgomery**                               |
|       |                 | Chief Executive Officer                               |
|       |                 |                                                  |
| DATE:      | October 2, 2006 |                                                  |       | /s/   DAVID  R. BROWN |   |
| ** ** |                 | **David R. Brown**                                    |
|       |                 | Principal Financial and Principal Accounting  Officer |
|            |                      |                                                       |            |  |  |  |

 

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