**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**Form 10-QSB**

 

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

**for the quarterly period ended September 30,2005**

 

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

 

**Commission File Number 0-15982**

 

**NATIONAL MERCANTILE BANCORP**

(Exact name of small business issuer in its charter)

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

 

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

 

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

 

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

 

The number of shares ofCommon Stock, no par value, of the issuer outstanding as of November 8,2005 was 4,338,274.

 

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

 

 

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PART I – FINANCIAL INFORMATION

 

*Item 1.** Financial Statements*

 

Presentedare the unaudited consolidated financial statements of National MercantileBancorp (“National Mercantile” on a parent-only basis, and the “Company” on aconsolidated basis) and its wholly-owned subsidiaries, Mercantile National Bank(“Mercantile”) and South Bay Bank, N.A. (“South Bay”), (collectively, the “Banks”).  

 

2

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**NATIONAL MERCANTILEBANCORP AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

(Unaudited)

 
| ** **                                                                                                                                                                                                    | ** ** | **September 30,**     | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                    | ** ** | **2005**                   | ** ** | **2004**              | ** ** |
| ** **                                                                                                                                                                                                    | ** ** | **(Dollars in thousands)** | ** ** |
| ASSETS                                                                                                                                                                                                        |       |                       |       |                  |       |
| Cash and due  from banks-demand                                                                                                                                                                               |       | $                          | 15,113     |                  | $          | 14,187 |   |
| Due from  banks-interest bearing                                                                                                                                                                              |       | 2,000                      |       | 2,728                 |       |
| Federal funds  sold                                                                                                                                                                                           |       | 3,110                      |       | —                |       |
| Cash and cash equivalents                                                                                                                                                                                     |       | 20,223                     |       | 16,915                |       |
| Securities available-for-sale, at fair value;  aggregate amortized cost of $56,763 and $37,020 at September 30, 2005  and December 31, 2004, respectively                                           |       | 56,382                     |       | 36,954                |       |
| Securities  held-to-maturity, at amortized cost                                                                                                                                                               |       | 2,795                      |       | 3,507                 |       |
| FRB and other  stock, at cost                                                                                                                                                                                 |       | 3,301                      |       | 3,076                 |       |
| Loans receivable                                                                                                                                                                                              |       | 330,179                    |       | 313,847               |       |
| Allowance for loan and lease losses                                                                                                                                                                           |       | (4,526                     | )          | (3,511                | )          |
| Net loans receivable                                                                                                                                                                                          |       | 325,653                    |       | 310,336               |       |
|                                                                                                                                                                                                          |       |                       |       |                  |       |
| Premises and  equipment, net                                                                                                                                                                                  |       | 5,840                      |       | 5,804                 |       |
| Other real  estate owned                                                                                                                                                                                      |       | 1,056                      |       | 1,056                 |       |
| Deferred tax  asset                                                                                                                                                                                           |       | 4,652                      |       | 5,286                 |       |
| Goodwill                                                                                                                                                                                                      |       | 3,225                      |       | 3,225                 |       |
| Core deposit  intangible, net                                                                                                                                                                                 |       | 1,463                      |       | 1,630                 |       |
| Accrued interest  receivable and other assets                                                                                                                                                                 |       | 3,893                      |       | 3,750                 |       |
| Total assets                                                                                                                                                                                                  |       | $                          | 428,483    |                  | $          | 391,539 |   |
|                                                                                                                                                                                                          |       |                       |       |                  |       |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY                                                                                                                                                                    |       |                       |       |                  |       |
| Deposits:                                                                                                                                                                                                     |       |                       |       |                  |       |
| Noninterest-bearing demand                                                                                                                                                                                    |       | $                          | 124,053    |                  | $          | 113,852 |   |
| Interest-bearing demand                                                                                                                                                                                       |       | 31,583                     |       | 34,961                |       |
| Money market                                                                                                                                                                                                  |       | 75,377                     |       | 69,431                |       |
| Savings                                                                                                                                                                                                       |       | 30,180                     |       | 32,199                |       |
| Time certificates of deposit:                                                                                                                                                                                 |       |                       |       |                  |       |
| $100,000 or more                                                                                                                                                                                              |       | 72,845                     |       | 41,111                |       |
| Under $100,000                                                                                                                                                                                                |       | 20,518                     |       | 21,988                |       |
| Total deposits                                                                                                                                                                                                |       | 354,556                    |       | 313,542               |       |
|                                                                                                                                                                                                          |       |                       |       |                  |       |
| Other borrowings                                                                                                                                                                                              |       | 19,000                     |       | 25,900                |       |
| Junior  subordinated deferrable interest debentures                                                                                                                                                           |       | 15,464                     |       | 15,464                |       |
| Accrued interest  payable and other liabilities                                                                                                                                                               |       | 2,376                      |       | 2,151                 |       |
| Total liabilities                                                                                                                                                                                             |       | 391,396                    |       | 357,057               |       |
|                                                                                                                                                                                                          |       |                       |       |                  |       |
| Shareholders’  equity:                                                                                                                                                                                   |       |                       |       |                  |       |
| Preferred stock, no par value - authorized 1,000,000  shares:                                                                                                                                                 |       |                       |       |                  |       |
| Series A non-cumulative convertible perpetual  preferred stock; authorized 990,000 shares; no shares and 666,273 shares outstanding  at September 30, 2005 and December 31, 2004, respectively |       | —                     |       | 5,442                 |       |
| Series B non-cumulative convertible perpetual  preferred stock; authorized 1,000 shares; 1,000 shares outstanding at September 30,  2005 and December 31, 2004                                 |       | 1,000                      |       | 1,000                 |       |
| Common stock, no par value; authorized 10,000,000  shares; 4,337,874 shares and 2,954,128 shares outstanding at September 30,  2005 and December 31, 2004, respectively                             |       | 45,290                     |       | 39,491                |       |
| Accumulated  deficit                                                                                                                                                                                          |       | (8,450                     | )          | (11,726               | )          |
| Accumulated  other comprehensive income (loss)                                                                                                                                                                |       | (753                       | )          | 275                   |       |
| Total shareholders’ equity                                                                                                                                                                               |       | 37,087                     |       | 34,482                |       |
| Total liabilities and shareholders’ equity                                                                                                                                                               |       | $                          | 428,483    |                  | $          | 391,539 |   |

 

See accompanying notes to consolidated financialstatements.

 

3

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**NATIONAL MERCANTILEBANCORP AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

(Unaudited)

 
| ** **                                                        | ** ** | **For the Three Months Ended  September 30,** | ** ** | **For the Nine Months Ended  September 30,** | ** ** |
|-------------------------------------------------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                        | ** ** | **2005**                                           | ** ** | **2004**                                          | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                        | ** ** | **(Dollars in thousands,  except per share data)** | ** ** |
| ** **                                                        | ** ** | ** **                                         | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest income:                                                  | ** ** | ** **                                         | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Loans, including fees                                             |       | $                                                  | 6,194      |                                              | $          | 5,067 |   | $ | 17,312 |   | $ | 12,772 |   |
| Securities                                                        |       | 523                                                |       | 403                                               |       | 1,268 |   | 1,073 |   |
| Due from banks - interest bearing                                 |       | 23                                                 |       | 12                                                |       | 57 |   | 40 |   |
| Federal funds sold                                                |       | 14                                                 |       | 5                                                 |       | 43 |   | 59 |   |
| Total interest income                                             |       | 6,754                                              |       | 5,487                                             |       | 18,680 |   | 13,944 |   |
|                                                              |       |                                               |       |                                              |       |   |   |   |   |
| Interest  expense:                                                |       |                                               |       |                                              |       |   |   |   |   |
| Deposits:                                                         |       |                                               |       |                                              |       |   |   |   |   |
| Interest-bearing demand                                           |       | 46                                                 |       | 19                                                |       | 113 |   | 55 |   |
| Money market and savings                                          |       | 350                                                |       | 195                                               |       | 804 |   | 541 |   |
| Time certificates of deposit:                                     |       |                                               |       |                                              |       |   |   |   |   |
| $100,000 or more                                                  |       | 323                                                |       | 93                                                |       | 790 |   | 250 |   |
| Under $100,000                                                    |       | 161                                                |       | 121                                               |       | 455 |   | 339 |   |
| Total interest expense on deposits                                |       | 880                                                |       | 428                                               |       | 2,162 |   | 1,185 |   |
| Junior subordinated deferrable interest debentures                |       | 326                                                |       | 259                                               |       | 903 |   | 713 |   |
| Other borrowings                                                  |       | 92                                                 |       | 105                                               |       | 225 |   | 278 |   |
| Total interest expense                                            |       | 1,298                                              |       | 792                                               |       | 3,290 |   | 2,176 |   |
| Net interest income before provision (benefit) for  credit losses |       | 5,456                                              |       | 4,695                                             |       | 15,390 |   | 11,768 |   |
| Provision  (benefit) for credit losses                            |       | (213                                               | )          | 120                                               |       | (124 | ) | 120 |   |
| Net interest income after provision (benefit) for  credit losses  |       | 5,669                                              |       | 4,575                                             |       | 15,514 |   | 11,648 |   |
|                                                              |       |                                               |       |                                              |       |   |   |   |   |
| Other operating  income:                                          |       |                                               |       |                                              |       |   |   |   |   |
| Net loss on sale of securities available-for-sale                 |       | —                                             |       | (95                                               | )          | — |   | (76 | ) |
| International services                                            |       | 11                                                 |       | 25                                                |       | 37 |   | 46 |   |
| Investment division                                               |       | 15                                                 |       | 13                                                |       | 44 |   | 38 |   |
| Deposit-related and other customer services                       |       | 252                                                |       | 374                                               |       | 818 |   | 1,176 |   |
| Total other operating income                                      |       | 278                                                |       | 317                                               |       | 899 |   | 1,184 |   |
|                                                              |       |                                               |       |                                              |       |   |   |   |   |
| Other operating  expenses:                                        |       |                                               |       |                                              |       |   |   |   |   |
| Salaries and related benefits                                     |       | 1,998                                              |       | 1,884                                             |       | 5,684 |   | 5,639 |   |
| Net occupancy                                                     |       | 257                                                |       | 270                                               |       | 742 |   | 885 |   |
| Furniture and equipment                                           |       | 127                                                |       | 91                                                |       | 378 |   | 389 |   |
| Printing and communications                                       |       | 128                                                |       | 144                                               |       | 392 |   | 425 |   |
| Insurance and regulatory assessments                              |       | 105                                                |       | 107                                               |       | 318 |   | 327 |   |
| Client services                                                   |       | 152                                                |       | 156                                               |       | 471 |   | 436 |   |
| Computer data processing                                          |       | 216                                                |       | 236                                               |       | 666 |   | 721 |   |
| Legal services                                                    |       | 133                                                |       | 53                                                |       | 589 |   | 234 |   |
| Other professional services                                       |       | 287                                                |       | 226                                               |       | 826 |   | 599 |   |
| Amortization of core deposit intangible                           |       | 55                                                 |       | 55                                                |       | 167 |   | 167 |   |
| Retirement of fixed assets and leasehold  improvements            |       | —                                             |       | —                                            |       | — |   | 43 |   |
| Promotion and other expenses                                      |       | 272                                                |       | 156                                               |       | 582 |   | 375 |   |
| Total other operating expenses                                    |       | 3,730                                              |       | 3,378                                             |       | 10,815 |   | 10,240 |   |
| Income before  income tax provision                               |       | 2,217                                              |       | 1,514                                             |       | 5,598 |   | 2,592 |   |
| Income tax  provision                                             |       | 920                                                |       | 642                                               |       | 2,323 |   | 1,084 |   |
| Net income                                                        |       | $                                                  | 1,297      |                                              | $          | 872 |   | $ | 3,275 |   | $ | 1,508 |   |
|                                                              |       |                                               |       |                                              |       |   |   |   |   |   |   |   |   |
| Earnings per  share:                                              |       |                                               |       |                                              |       |   |   |   |   |
| Basic                                                             |       | $                                                  | 0.30       |                                              | $          | 0.30 |   | $ | 0.94 |   | $ | 0.52 |   |
| Diluted                                                           |       | $                                                  | 0.27       |                                              | $          | 0.19 |   | $ | 0.70 |   | $ | 0.33 |   |

 

See accompanying notes to consolidated financial statements.

 

4

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**NATIONAL MERCANTILEBANCORP AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

(Unaudited)

 
| ** **                                                                                   | ** ** | **For the Nine Months Ended September 30,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                   | ** ** | **2005**                                         | ** ** | **2004** | ** ** |
| ** **                                                                                   | ** ** | **(Dollars in thousands)**                       | ** ** |
| Cash flows from  operating activities:                                                       |       |                                             |       |   |   |
| Net income                                                                                   |       | $                                                | 3,275      |   | $ | 1,508 |   |
| Adjustments to reconcile net income to net cash  provided by (used in) operating activities: |       |                                             |       |   |   |
| Depreciation and amortization                                                                |       | 315                                              |       | 338 |   |
| Provision (benefit) for credit losses                                                        |       | (124                                             | )          | 120 |   |
| Loss on sale of securities available for sale                                                |       | —                                           |       | 76 |   |
| Net amortization of premium on securities available-for-sale                                 |       | 42                                               |       | 171 |   |
| Net amortization of premium on securities held-to-maturity                                   |       | 24                                               |       | 37 |   |
| Net amortization of core deposit intangible                                                  |       | 167                                              |       | 167 |   |
| Net amortization of premium on loans purchased                                               |       | 121                                              |       | 145 |   |
| (Increase) decrease in accrued interest receivable  and other assets                         |       | 212                                              |       | (3,429 | ) |
| Increase in accrued interest payable and other  liabilities                                  |       | 1,058                                            |       | 202 |   |
| Net cash provided by (used in) operating activities                                          |       | 5,090                                            |       | (665 | ) |
|                                                                                         |       |                                             |       |   |   |
| Cash flows from  investing activities:                                                       |       |                                             |       |   |   |
| Purchase of securities available-for-sale                                                    |       | (23,531                                          | )          | (22,532 | ) |
| Proceeds from sales of securities available-for-sale                                         |       | —                                           |       | 6,397 |   |
| Proceeds from repayments and maturities of  securities available-for-sale                    |       | 3,746                                            |       | 5,586 |   |
| Proceeds from repayments and maturities of  securities held-to-maturity                      |       | 688                                              |       | 784 |   |
| Loan originations and principal collections, net                                             |       | (17,796                                          | )          | (42,726 | ) |
| Recoveries of loans previously charged off                                                   |       | 1,216                                            |       | 130 |   |
| Net purchase of Federal Reserve Stock and other  stocks                                      |       | (225                                             | )          | (1,084 | ) |
| Purchases of premises and equipment                                                          |       | (351                                             | )          | (589 | ) |
| Net cash used in investing activities                                                        |       | (36,253                                          | )          | (54,034 | ) |
|                                                                                         |       |                                             |       |   |   |
| Cash flows from  financing activities:                                                       |       |                                             |       |   |   |
| Net increase in demand deposits, money market and  savings accounts                          |       | 10,750                                           |       | 16,087 |   |
| Net increase in time certificates of deposit                                                 |       | 30,264                                           |       | 7,745 |   |
| Net decrease in securities sold under agreements to  repurchase and federal funds purchased  |       | —                                           |       | (399 | ) |
| Net increase (decrease) in other borrowings                                                  |       | (6,900                                           | )          | 24,400 |   |
| Net proceeds from exercise of stock options                                                  |       | 357                                              |       | 165 |   |
| Net cash provided by financing activities                                                    |       | 34,471                                           |       | 47,998 |   |
| Net increase  (decrease) in cash and cash equivalents                                        |       | 3,308                                            |       | (6,701 | ) |
| Cash and cash  equivalents, January 1                                                   |       | 16,915                                           |       | 39,284 |   |
| Cash and cash  equivalents, September 30                                                |       | $                                                | 20,223     |   | $ | 32,583 |   |
|                                                                                         |       |                                             |       |   |   |
| Supplemental  disclosures of cash flow information:                                          |       |                                             |       |   |   |
| Cash paid for interest                                                                       |       | $                                                | 3,537      |   | $ | 2,358 |   |
| Cash paid for income taxes                                                                   |       | $                                                | 960        |   | $ | 51 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

5

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**NATIONAL MERCANTILE BANCORP ANDSUBSIDIARIES**

###### **NOTES TO THE UNAUDITEDCONSOLIDATED FINANCIAL STATEMENTS**

 

NOTE 1—BASIS OF PRESENTATION AND MANAGEMENT REPRESENTATIONS

 

The unauditedconsolidated financial statements include the accounts of National MercantileBancorp (“National Mercantile” on a parent-only basis, and the “Company” on aconsolidated basis) and its wholly-owned subsidiaries, Mercantile National Bankand South Bay Bank, N.A., (collectively, the “Banks”).  The 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 and nine months ended September 30, 2005 are notnecessarily indicative of the results expected for any subsequent period or forthe full year ending December 31, 2005. The unaudited consolidated financial statements should be read inconjunction with the audited consolidated financial statements included in theCompany’s Annual Report on Form 10-KSB for the year ended December 31,2004.

 

NOTE 2—EARNINGS PER SHARE

 

Basic earnings per shareare computed using the weighted average number of common shares outstandingduring the period.  The weighted averagenumber of common shares outstanding used in computing basic earnings per shareand diluted earnings per share was 4,327,175 and 4,740,664, respectively, forthe three months ended September 30, 2005 and 3,480,560 and 4,699,097,respectively, for the nine months ended September 30, 2005.  The weighted average number of common sharesoutstanding used in computing basic earnings per share and diluted earnings pershare was 2,918,583 and 4,565,379, respectively, for the three months ended September 30,2004 and 2,878,595 and 4,593,926, respectively, for the nine months ended September 30,2004.

 

The following table is areconciliation of income and shares used in the computation of basic anddiluted earnings per share:

 

6

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| ** **                                             | ** ** | **Earnings  available to  shareholders** | ** ** | **Weighted  Average  Shares** | ** ** | **Per share  amount** | ** ** |
|--------------------------------------------------------|------------|------------------------------------------|------------|-------------------------------|------------|-----------------------|------------|
| ** **                                             | ** ** | **(in thousands)**                       | ** ** | ** **                    | ** ** | ** **            | ** ** |
| ** **                                             | ** ** | ** **                               | ** ** | ** **                    | ** ** | ** **            | ** ** |
| *For the  three months ended September 30, 2005:* |       |                                     |       |                          |       |                  |       |
| Basic EPS                                              |       | $                                        | 1,297      |                          | 4,327,175  |                  | $          | 0.30 |   |
|                                                   |       |                                     |       |                          |       |                  |       |
| Effect of dilutive securities:                         |       |                                     |       |                          |       |                  |       |
| Options                                                |       |                                     |       | 227,117                       |       |                  |       |
| Convertible preferred stock                            |       |                                     |       | 186,372                       |       |                  |       |
| Diluted earnings per share                             |       | $                                        | 1,297      |                          | 4,740,664  |                  | $          | 0.27 |   |
|                                                   |       |                                     |       |                          |       |                  |       |
| *For the  three months ended September 30, 2004:* |       |                                     |       |                          |       |                  |       |
| Basic EPS                                              |       | $                                        | 872        |                          | 2,918,583  |                  | $          | 0.30 |   |
|                                                   |       |                                     |       |                          |       |                  |       |
| Effect of dilutive securities:                         |       |                                     |       |                          |       |                  |       |
| Options                                                |       |                                     |       | 138,431                       |       |                  |       |
| Convertible preferred stock                            |       |                                     |       | 1,508,365                     |       |                  |       |
| Diluted earnings per share                             |       | 872                                      |       | 4,565,379                     |       | $                     | 0.19       |   |
|                                                   |       |                                     |       |                          |       |                  |       |
| *For the  nine months ended September 30, 2005:*  |       |                                     |       |                          |       |                  |       |
| Basic EPS                                              |       | $                                        | 3,275      |                          | 3,480,560  |                  | $          | 0.94 |   |
|                                                   |       |                                     |       |                          |       |                  |       |
| Effect of dilutive securities:                         |       |                                     |       |                          |       |                  |       |
| Options                                                |       |                                     |       | 208,072                       |       |                  |       |
| Convertible preferred stock                            |       |                                     |       | 1,010,465                     |       |                  |       |
| Diluted earnings per share                             |       | $                                        | 3,275      |                          | 4,699,097  |                  | $          | 0.70 |   |
|                                                   |       |                                     |       |                          |       |                  |       |
| *For the  nine months ended September 30, 2004:*  |       |                                     |       |                          |       |                  |       |
| Basic EPS                                              |       | $                                        | 1,508      |                          | 2,878,595  |                  | $          | 0.52 |   |
|                                                   |       |                                     |       |                          |       |                  |       |
| Effect of dilutive securities:                         |       |                                     |       |                          |       |                  |       |
| Options                                                |       |                                     |       | 209,998                       |       |                  |       |
| Convertible preferred stock                            |       |                                     |       | 1,505,333                     |       |                  |       |
| Diluted earnings per share                             |       | $                                        | 1,508      |                          | 4,593,926  |                  | $          | 0.33 |   |

 

 

NOTE 3—CASH AND CASH EQUIVALENTS

 

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

 

7

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NOTE 4—ALLOWANCE FOR CREDIT LOSSES 

 

The allowance for creditlosses is the sum of the allowance for loan and lease losses and the reservefor contingent losses on unfunded commitments. The allowance for loan and lease losses is a valuation adjustment used torecognize impairment of the recorded investment in the Company’s loansreceivable on its balance sheet before losses have been confirmed resulting ina subsequent charge-off or write-down. The reserve for contingent losses on unfunded commitments is a liabilityaccrual for unidentified but probable losses on the Company’s commitments to fundloans.  As of September 30, 2005,the reserve for contingent losses on unfunded commitments has been reclassifiedfrom the allowance for loan and lease losses to other liabilities.  The 2004 year end reserve for contingentlosses on unfunded commitments has been reclassified to conform to the currentpresentation.

 

Provisions for creditlosses charged (or credited) to operations reflect management’s judgment of theadequacy of the allowance for credit losses and are determined through periodicanalysis of the loan portfolio.  Thisanalysis includes a systematic and detailed review of the classification andcategorization of problem loans; an assessment of the overall quality andcollectibility of the portfolio; and consideration of the loan loss experience,trends in problem loans, concentrations of credit risk, as well as current economicconditions (particularly Southern California). During the third quarter 2005, Management modified the methodology forevaluating the adequacy of the allowance for credit losses to (i) conformthe analyses between its subsidiaries, (ii) recognize a factor forprobable losses in the Company’s adjustable rate loans resulting from increasingborrower difficulty to service debt in a rising interest rate environment, and (iii) recognizea factor for greater probable losses in certain higher risk loan segmentsincluding film production finance and consumer overdrafts.  These additional factors resulted in $571,000additional allowance for credit losses.  Managementperforms a periodic risk and credit analysis, the results of which are reportedto the Board of Directors.

 

During the third quarter2005, the Company recovered $1.1 million from a loan previously charged off andthe recovery was added to the allowance for loan and lease losses.  Pursuant to Management’s evaluation of theallowance for credit losses at September 30, 2005, a benefit for creditlosses of $213,000 was recorded for the third quarter 2005.

 

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

 

8

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**Analysis of Changesin Allowance for Credit Losses**

 
| ** **                                          | ** ** | **Allowance for Loan  and Lease Losses** | ** ** | **Reserve for  Contingent Losses  on Unfunded  Commitments** | ** ** | **Allowance for  Credit Losses** | ** ** |
|-----------------------------------------------------|------------|------------------------------------------|------------|--------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                          | ** ** | ** **                               | ** ** | **(Dollars in thousands)**                                   | ** ** | ** **                       | ** ** |
| For the three  months ended September 30, 2005 |       |                                     |       |                                                         |       |                             |       |
| Balance, beginning of period                        |       | $                                        | 3,669      |                                                         | $          | 477                              |       | $ | 4,146 |   |
| Total loans charged-off                             |       | —                                   |       | —                                                       |       | —                           |       |
| Total recoveries of loans previously charged off    |       | 1,081                                    |       | —                                                       |       | 1,081                            |       |
| Net charge-offs                                     |       | (1,081                                   | )          | —                                                       |       | (1,081                           | )          |
| Provision for credit losses                         |       | (224                                     | )          | 11                                                           |       | (213                             | )          |
| Balance, end of period                              |       | $                                        | 4,526      |                                                         | $          | 488                              |       | $ | 5,014 |   |
|                                                |       |                                     |       |                                                         |       |                             |       |
| For the three  months ended September 30, 2004 |       |                                     |       |                                                         |       |                             |       |
| Balance, beginning of period                        |       | $                                        | 3,312      |                                                         | $          | 379                              |       | $ | 3,691 |   |
| Total loans charged-off                             |       | —                                   |       | —                                                       |       | —                           |       |
| Total recoveries of loans previously charged off    |       | 39                                       |       | —                                                       |       | 39                               |       |
| Net charge-offs                                     |       | (39                                      | )          | —                                                       |       | (39                              | )          |
| Provision for credit losses                         |       | 132                                      |       | (12                                                          | )          | 120                              |       |
| Balance, end of period                              |       | $                                        | 3,483      |                                                         | $          | 367                              |       | $ | 3,850 |   |
|                                                |       |                                     |       |                                                         |       |                             |       |
| For the nine  months ended September 30, 2005  |       |                                     |       |                                                         |       |                             |       |
| Balance, beginning of period                        |       | $                                        | 3,511      |                                                         | $          | 417                              |       | $ | 3,928 |   |
| Total loans charged-off                             |       | 6                                        |       | —                                                       |       | 6                                |       |
| Total recoveries of loans previously charged off    |       | 1,216                                    |       | —                                                       |       | 1,216                            |       |
| Net charge-offs                                     |       | (1,210                                   | )          | —                                                       |       | (1,210                           | )          |
| Provision for credit losses                         |       | (195                                     | )          | 71                                                           |       | (124                             | )          |
| Balance, end of period                              |       | $                                        | 4,526      |                                                         | $          | 488                              |       | $ | 5,014 |   |
|                                                |       |                                     |       |                                                         |       |                             |       |
| For the nine  months ended September 30, 2004  |       |                                     |       |                                                         |       |                             |       |
| Balance, beginning of period                        |       | $                                        | 3,268      |                                                         | $          | 367                              |       | $ | 3,635 |   |
| Total loans charged-off                             |       | 35                                       |       | —                                                       |       | 35                               |       |
| Total recoveries of loans previously charged off    |       | 130                                      |       | —                                                       |       | 130                              |       |
| Net charge-offs                                     |       | (95                                      | )          | —                                                       |       | (95                              | )          |
| Provision for credit losses                         |       | 120                                      |       | —                                                       |       | 120                              |       |
| Balance, end of period                              |       | $                                        | 3,483      |                                                         | $          | 367                              |       | $ | 3,850 |   |

 

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.

 

9

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NOTE 5—GOODWILL AND CORE DEPOSIT INTANGIBLES

 

As of September 30,2005 and December 31, 2004, the Company had recognized goodwill of $3.2million, and net core deposit intangibles of $1.5 million and $1.6 million,respectively, from its acquisition of South Bay Bank in December 2001.  The gross carrying amount of core depositintangibles was $2.3 million at September 30, 2005 and December 31,2004, and accumulated amortization was $837,000 and $670,000, respectively, atsuch dates.  The core deposit intangiblesare estimated to have a life of 10 years and 4 months.  Amortization for intangibles for 2005 and eachof the next four years is estimated to be $223,000 per year.  In accordance with SFAS No. 142 goodwillis not amortized.  The Company has noother recorded indefinite-lived intangible assets.  Goodwill and other intangible assets arereviewed and assessed annually for impairment or more frequently if conditionssuggest impairment may exist.

 

NOTE 6—INCOME TAXES

 

Income tax provisions of$920,000 and $642,000 were recorded for the three months ended September 30,2005 and 2004, respectively.  Income taxprovisions of $2,323,000 and $1,084,000 were recorded for the nine months endedSeptember 30, 2005 and 2004, respectively.

 

At September 30,2005, the Company had: (i) federal net operating loss carry forwards (“NOLS”)of approximately $8.3 million, which begin to expire in the year 2009; and (ii) federalalternative minimum tax “AMT” credits of $495,000.  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 7—BENEFIT PLANS

 

The estimated per shareweighted average fair value of options granted in the three months ended September 30,2005 was $9.57.  There were no stockoptions granted in the three months ended September 30, 2004.  The estimated per share weighted average fairvalue of options granted in the nine months ended September 30, 2005 and2004 was $9.58 and $6.95, respectively. The Company applies Accounting Principles Board Opinion No. 25 andrelated interpretations in accounting for its stock incentive plans.  SFAS No. 123, Accounting for Stock-BasedCompensation, encourages, but does not require, companies to recordcompensation cost for stock-based employee compensation plans at fairvalue.  Accordingly and in

 

10

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accordancewith the principle contained in APBO 25, no compensation cost has beenrecognized for the options.  Hadcompensation cost for the options granted been determined based on the fairvalue at the grant dates for awards consistent with the method of SFAS No. 123,the Company’s net income for the three months and nine months ended September 30,2005 and 2004 would have decreased to the pro forma amounts indicated below:

 
| ** **                                                                                                                            | ** ** | **Three Months Ended September 30,**          | ** ** | **Nine Months Ended September 30,**           | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                                                                                                            | ** ** | **2005**                                           | ** ** | **2004**                                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                                                            | ** ** | **(Dollars in thousands,  except per share data)** | ** ** | **(Dollars in thousands,  except per share data)** | ** ** |
| Net income:                                                                                                                           |       |                                               |       |                                               |       |   |   |   |   |
| As reported                                                                                                                           |       | $                                                  | 1,297      |                                               | $          | 872 |   | $ | 3,275 |   | $ | 1,508 |   |
|                                                                                                                                  |       |                                               |       |                                               |       |   |   |   |   |
| Total stock-based employee compensation expense  determined under fair value based method for all awards, net of related tax  effects |       | 90                                                 |       | 52                                                 |       | 190 |   | 140 |   |
| Pro forma                                                                                                                             |       | $                                                  | 1,207      |                                               | $          | 820 |   | $ | 3,085 |   | $ | 1,368 |   |
|                                                                                                                                  |       |                                               |       |                                               |       |   |   |   |   |
| Income per share as reported:                                                                                                         |       |                                               |       |                                               |       |   |   |   |   |
| Basic                                                                                                                                 |       | $                                                  | 0.30       |                                               | $          | 0.30 |   | $ | 0.94 |   | $ | 0.52 |   |
| Diluted                                                                                                                               |       | 0.27                                               |       | 0.19                                               |       | 0.70 |   | 0.33 |   |
| Income per share pro forma:                                                                                                           |       |                                               |       |                                               |       |   |   |   |   |
| Basic                                                                                                                                 |       | $                                                  | 0.28       |                                               | $          | 0.28 |   | $ | 0.89 |   | $ | 0.48 |   |
| Diluted                                                                                                                               |       | 0.25                                               |       | 0.18                                               |       | 0.66 |   | 0.30 |   |

 

The fair values ofoptions granted during the three months ended September 30, 2005 and 2004were estimated on the date of grant using the Black-Scholes option-pricingmodel with the following weighted-average assumptions used: 2005— no dividendyield, expected volatility of 43%, risk-free interest rate of 4.38%, and anexpected life of 10 years; 2004— no dividend yield, expected volatility of 57%,risk-free interest rate of 4.21%, and an expected life of 10 years.

 

The Financial AccountingStandards Board (“FASB”) issued SFAS No. 123(R), “Share-Based Payment” in December 2004,which requires entities that grant stock options and shares to employees torecognize the fair value of those options and shares as compensation cost overthe service (vesting) period in their financial statements.  For public entities, such as NationalMercantile, that file as small business issuers the effective date for SFAS No. 123(R)is the first interim or annual reporting period that begins after December 15,2005.  Consequently, upon adoption ofSFAS No. 123R the compensation cost for options granted will be treated asan expense.  The Company intends to adoptFAS No. 123R on January 1, 2006 and is currently evaluating theimpact the adoption of the standard will have on the Company’s results ofoperations.

 

11

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NOTE 8—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:

 
| ** **                                                                          | ** ** | **Three Months ended September 30,** | ** ** | **Nine Months ended September 30,** | ** ** |
|-------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                          | ** ** | **2005**                                  | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                          | ** ** | **(Dollars in thousands)**                | ** ** | **(Dollars in thousands)**               | ** ** |
|                                                                                |       |                                      |       |                                     |       |   |   |   |   |
| Net income                                                                          |       | $                                         | 1,297      |                                     | $          | 872 |   | $ | 3,275 |   | $ | 1,508 |   |
|                                                                                |       |                                      |       |                                     |       |   |   |   |   |
| Other comprehensive income (loss) before tax, and  unrealized losses on securities: |       |                                      |       |                                     |       |   |   |   |   |
| Unrealized gain (loss) on interest rate swaps used  in cash flow hedges             |       | (896                                      | )          | 1,017                                    |       | (1,266 | ) | 1,017 |   |
| Unrealized gain (loss) on interest rate floors used  in cash flow hedges            |       | (151                                      | )          | —                                   |       | (176 | ) | — |   |
| Unrealized gain (loss) on securities available for  sale                            |       | (281                                      | )          | 261                                      |       | (315 | ) | (85 | ) |
| Other comprehensive income (loss), before tax                                       |       | (1,328                                    | )          | 1,278                                    |       | (1,757 | ) | 932 |   |
|                                                                                |       |                                      |       |                                     |       |   |   |   |   |
| Income tax benefit (expense) related to items of  other comprehensive income        |       | 551                                       |       | (529                                     | )          | 730 |   | (387 | ) |
| Other comprehensive income (loss)                                                   |       | (777                                      | )          | 749                                      |       | (1,027 | ) | 545 |   |
| Total comprehensive income                                                          |       | $                                         | 520        |                                     | $          | 1,621 |   | $ | 2,248 |   | $ | 2,053 |   |

 

NOTE 9—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 are accountedfor according to SFAS No. 133, Accounting for Derivative Instruments andHedging Activities, as amended. This standard requires that all derivativeinstruments be recognized in the financial statements and measured at fairvalue regardless of the purpose or intent for holding them.  To qualify for hedge accounting, the detailsof the hedging relationship must be formally documented at inception of thearrangement, including the risk management objective, hedging strategy, hedgeditem, specific risks that are being hedged, the derivative instrument and howeffectiveness is being assessed.

 

12

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The derivative must be highly effective in offsettingeither changes in fair value or cash flows, as appropriate, for the risk beinghedged.  Effectiveness is evaluated on aretrospective and prospective basis. If a hedge relationship becomesineffective, it no longer qualifies as a hedge. Any excess gains or lossesattributable to such ineffectiveness, as well as subsequent changes in the fairvalue of the derivative, are recognized in earnings.

 

  The following is a summary of our riskmanagement strategies and the effect of these strategies on the consolidatedfinancial statements.

 
| ** **           | ** ** | **September 30, 2005** | ** ** | **December 31, 2004** | ** ** |
|----------------------|------------|-----------------------------|------------|----------------------------|------------|
| ** **           | ** ** | **Notional  Amount**        | ** ** | **Fair Value**             | ** ** | **Notional  Amount** | ** ** | **Fair Value** | ** ** |
| ** **           | ** ** | **(Dollars in thousands)**  | ** ** |
| Fair value  hedges:  |       |                        |       |                       |       |   |   |   |   |
| Interest rate swaps  |       | $                           | 15,000     |                       | $          | (296 | ) | $ | 15,000 |   | $ | (311 | ) |
|                 |       |                        |       |                       |       |   |   |   |   |
| Cash flow  hedges:   |       |                        |       |                       |       |   |   |   |   |
| Interest rate swaps  |       | $                           | 50,000     |                       | $          | (743 | ) | $ | 50,000 |   | $ | 406 |   |
| Interest rate floors |       | $                           | 75,000     |                       | $          | 196 |   | $ | — |   | $ | — |   |
|                 |       |                        |       |                       |       |   |   |   |   |
| Other  derivatives:  |       |                        |       |                       |       |   |   |   |   |
| Interest rate floors |       | $                           | 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 junior subordinated deferrable interestdebentures.  The interest rate swapsresult in the Company paying or receiving the difference between the fixed andfloating rates at specified 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 effective andtherefore no ineffectiveness was recognized in current earnings related to thisswap.

 

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 September 30,2005 a loss of $435,000 was recorded in accumulated other comprehensive incomeand no ineffectiveness was recorded to earnings for the three months and ninemonths ended September 30, 2005 related to these interest rate swaps.  At September 30, 2005 a loss of $107,000was recorded in accumulated other comprehensive income related to the interestrate floors.  Ineffectiveness related tothe interest rate floors

 

13

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designatedas cash flow hedges of $18,000 and $24,000 was charged to earnings for thethree and nine months ended September 30, 2005, respectively.

 

Other derivatives notdesignated as hedges are interest rate floors 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 market through earnings.  There was an $8,000 charge to earnings duringthe second quarter 2005 writing the value of this floor to zero and there was nochange in market value for these derivatives recorded to earnings for the threemonths ended September 30, 2005.

 

NOTE 10— CONVERSION OF PREFERRED STOCK

 

Pursuant to the electionof the holders of a majority of the outstanding shares of Series ANoncumulative Perpetual Convertible Preferred Stock (the “Series APreferred”) of National Mercantile Bancorp (the “Company”) on June 23,2005, each outstanding share of the Company’s Series A Preferred wasautomatically converted into two shares of the Company’s Common Stock inaccordance with the Company’s Amended and Restated Articles of Incorporation,as amended.  As a result of this conversion, 643,893 shares of Series A Preferred were converted into 1,287,786 shares of CommonStock. During the nine months ended September 30, 2005, 666,273 shares of Series A Preferred were converted into 1,332,546 shares of commonstock.

 

NOTE 11—RECLASSIFICATIONS

 

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

 

14

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***Item 2.******                     ******MANAGEMENT’S DISCUSSION ANDANALYSIS 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.

 

**RESULTS OF OPERATIONS OVERVIEW**

 

The Company recorded netincome of $1,297,000, or $0.30 basic earnings per share and $0.27 dilutedearnings per share, for the three months ended September 30, 2005 comparedto net income of $872,000, or $0.30 basic earnings per share and $0.19 dilutedearnings per share, for the same period of 2004.  The increase in net income for the thirdquarter of 2005 was primarily due to a $761,000 increase in net interest incomebefore the provision for credit losses resulting from increases in the primerate lending index, a greater volume of interest earning assets, particularlyhigher-yielding loans receivable and securities available-for-sale, and afavorable change in earning asset and funding liability composition.  Third quarter 2005 net income was furtherenhanced by a $333,000 decrease in the provision for loan losses compared tothe 2004 period offset by a $352,000 increase in noninterest expense.

 

Pursuant to the electionof the holders of a majority of the outstanding shares of the Company’s Series ANoncumulative Perpetual Convertible Preferred Stock (the “Series APreferred”) on June 23, 2005, each outstanding share of the Company’s Series APreferred was automatically converted into two shares of the Company’s CommonStock in accordance with the Company’s Amended and Restated Articles ofIncorporation, as amended.  As a resultof this conversion, 643,893 shares of Series APreferred were converted into 1,287,786 shares of Common Stock.  The Series APreferred were previously included in the dilutive shares outstanding but notbasic shares outstanding for earnings per share computation.

 

The Company recorded netincome of $3.3 million, or $0.94 basic earnings per share and $0.70 dilutedearnings per share, for the nine months ended September 30, 2005 comparedto net income of $1.5 million, or $0.52 basic earnings per share and $0.33diluted earnings per share, for the same period of 2004.  The increase in net income for the 2005period was primarily due to a $3.6 million increase in net interest incomebefore provision for credit losses resulting from increases in the prime ratelending index, interest rate swaps, a greater volume of interest earningassets, particularly higher-yielding loans receivable and securitiesavailable-for-sale, and a favorable change in earning asset and fundingliability composition.  The provision forloan

 

15

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lossesduring the 2005 period decreased $244,000 compared to the 2004 period, whileother operating income decreased $285,000 and noninterest expense increased$575,000.

 

Return on average assetsduring the third quarter and first nine months of 2005 was 1.27% and 1.11%,respectively, compared to 0.88% and 0.53% during the third quarter and firstnine months of 2004, respectively.  Return on average equity during the thirdquarter and first nine months of 2005 was 13.77% and 12.11%, respectively,compared to 10.47% and 6.18% during the third quarter and first nine months of2004, respectively.

 

NET INTEREST INCOME

 

Net interest incomebefore the provision for credit losses increased $761,000 for the three monthsended September 30, 2005 compared to the same quarter of 2004 due to a $1.3million increase in total interest income partially offset by a $506,000increase in interest expense.  Loaninterest income increased $1.1 million due to an $18.1 million greater averagevolume of loans receivable and a 101 basis point increase in yield, resulting primarilyfrom increases in the prime rate lending index. During the second half of 2004 and first nine months of 2005, theFederal Reserve Bank increased the federal funds rate on eleven occasionstotaling 275 basis points, after a prolonged period of accommodative monetarypolicy, in response to signs of increasing inflation risks.  Approximately 75% of the $330.2 million loansreceivable have adjustable interest rates; accordingly, rising interest ratespositively affect interest income partially offset by greater payments on our$50 million of prime rate-indexed interest rate swaps.  The greater loan volume was primarily due to themore rapid funding of construction loans originated in earlier periods and fewerpayoffs of commercial real estate loans.

 

Interest income fromsecurities available-for-sale increased during the third quarter 2005 comparedto the third quarter 2004 due to a $3.9 million increase in average volume anda 75 basis point increase in yield.  At September 30,2005 securities available-for-sale were $56.4 million, an increase of $19.4million from December 31, 2004.  Thepurchase of securities was accelerated during the third quarter 2005 to extendthe duration of portfolio assets in order to reduce the Company’s assetsensitivity.  The increase in the yieldon securities available-for-sale was due to higher yields on the more recently purchasedsecurities due to rising market interest rates.

 

Overall, interest-earningassets were $20.3 million greater during the third quarter 2005 than thirdquarter 2004 and the higher yields and favorable change in composition tohigher-yielding assets resulted in a 99 basis point increase in weightedaverage yield on interest-earning assets.

 

16

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Interest expenseincreased $506,000 for the three months ended September 30, 2005 comparedto the same period in 2004, due primarily to an 82 basis point increase in costof funds.  Average interest-bearingliabilities increased $3.1 million for the third quarter 2005 compared to thesame period in 2004; the composition of interest-bearing liabilities, however,changed significantly.  During the risinginterest rate environment experienced during the past five quarters, theCompany elected to only moderately increase transaction deposit rates and tofund runoff of these deposits with brokered certificates of deposit. This typeof funding is typically higher costing and exhibits higher interest ratesensitivity.  While rates are higher oncertificates of deposit, the greater interest expense on the incrementalcertificates of deposit needed to fund the decrease in transaction deposits isless than the impact of increasing rates on the significantly greater volume oftransaction accounts.  Consequently,money market and savings deposits averaged $10.3 million less in the 2005 periodcompared to the 2004 period due to depositors redeploying their funds to theCompany’s higher yielding certificates of deposit and alternative investmentsoutside the Banks.  The cost of interest-bearingdemand deposits and money market and savings deposits increased 29 basis pointsand 67 basis points, respectively, compared to the third quarter of 2004.  Time certificates of deposit averaged $23.8million more during the third quarter 2005 than the same period in 2004 while thecost increased 89 basis points due to higher rates on new certificates andrepricing of matured certificates during the higher interest rateenvironment.  In a sustained risinginterest rate environment, increases in deposit interest rates will be requiredto prevent net deposit withdrawals.

 

Additionally, otherborrowings were repaid with lower cost brokered deposits.  Other borrowings during the third quarter2005 averaged $9.9 million, or $13.1 million less thanthe same period in 2004.  The cost ofother borrowings was 3.68% and 1.82% for the third quarters of 2005 and 2004,respectively, representing an increase of 186 basis points for the 2005 period.  Noninterest-bearing demand deposits increased$2.7 million in average volume in the third quarter 2005 compared to the sameperiod in 2004.

 

The net yield on interestearning assets increased 51 basis points from 5.26% during the third quarter in2004 to 5.77% in the third quarter in 2005, while the net interest spreadincreased 17 basis points from 4.81% during the third quarter in 2004 to 4.98%in the third quarter in 2005.

 

Net interest incomebefore the provision for credit losses increased $3.6 million for the ninemonths ended September 30, 2005 compared to the same period of 2004 due toa $4.7 million increase in total interest income partially offset by a $1.1million increase in interest expense. Loan interest income increased $4.5 million due to $32.1 million greateraverage volume of loans receivable and a 133 basis point increase in yield,resulting primarily from increases in the prime rate lending index as well asinterest income recorded from the interest rate swaps.  On July 1, 2004, the Banks entered intointerest rate swap

 

17

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agreementsin which they exchanged an adjustable rate interest based on the prime ratelending index for a fixed rate payment of 6.925% on an aggregate notionalprincipal amount of $50.0 million (see Note 9—Derivative Financial Instrumentsof the Notes to Consolidated Financial Statements for details of the swapterms).  Thus, the interest rate swapscontributed interest income for the full nine months of 2005 but only the thirdquarter of 2004.  The interest rate swapscontributed 16 basis points to the increase in loan yield during 2005.

 

Interest income fromsecurities available-for-sale increased $219,000 during the first nine monthsof 2005 compared to the first nine months of 2004 due to a 55 basis pointincrease in yield with average volume increasing $1.6 million.  The increase in the yield on securitiesavailable-for-sale was due to higher yields on the more recently purchasedsecurities.

 

Overall, interest-earningassets were $25.2 million greater during the first nine months of 2005 than firstnine months of 2004 and the higher yields and favorable change in compositionto higher-yielding assets resulted in a 137 basis point increase in weightedaverage yield on interest-earning assets.

 

Interest expenseincreased $1.1 million for the nine months ended September 30, 2005compared to the same period in 2004, due to an $11.0 million increase inaverage interest-bearing liabilities and a 59 basis point increase in cost offunds.  Interest expense on depositsincreased $1.0 million for the nine months ended September 30, 2005compared to the same period in 2004 due to a 58 basis point increase inweighted average cost and a $14.6 million increase in average interest-bearingdeposits.  Relatively low costing moneymarket and savings deposits averaged $7.8 million less in the 2005 periodcompared to the 2004 period.  The decreasein transactional deposits is due to depositors redeploying their funds tohigher yielding certificates of deposit and alternative investments outside theBanks.  Time certificates of depositaveraged $21.3 million more during the first nine months of 2005 than the sameperiod in 2004.  The cost of timecertificates of deposit increased 76 basis points due to higher rates on newcertificates and repricing of matured certificates during the higher interestrate environment.  Rising market rates ofinterest during the latter half of 2004 and first nine months of 2005 resultedin the cost of interest-bearing demand deposits and money market and savingsdeposits increasing 24 basis points and 40 basis points, respectively, comparedto the first nine months of 2004.  Otherborrowings during the first nine months of 2005 averaged $10.1 million, or $3.6million less than the same period in 2004. The cost of other borrowings was 2.97% and 2.70% for the first ninemonths of 2005 and 2004, respectively, representing an increase of 27 basispoints in 2005 due to an increase in market rates of interest.  Noninterest-bearing demand deposits wererelatively stable, with an increase of $2.2 million in average volume in the firstnine months of 2005 compared to 2004.

 

18

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The net yield on interestearning assets increased 102 basis points from 4.68% during the first ninemonths of 2004 to 5.70% in the first nine months of 2005, while the netinterest spread increased 78 basis points from 4.23% during the first ninemonths of 2004 to 5.01% in the first nine months in 2005.

 

The following tablepresents the components of net interest income for the three months ended September 30,2005 and 2004.

 

19

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**Average Balance Sheetand**

**Analysis of NetInterest Income**

 
| ** **                                                                                     | ** ** | **Three Months ended**      | ** ** |
|------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                     | ** ** | **September 30, 2005** | ** ** | **September 30, 2004** | ** ** |
| ** **                                                                                     | ** ** | ** **                  | ** ** | ** ** | ** ** | **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 purchased under  agreements to resell                        |       | $                           | 1,604      |   | 14 |   | 3.46 | % | $ | 1,558 |   | 5 |   | 1.28 | % |
| Due from  banks-interest bearing                                                               |       | 2,000                       |       | 23 |   | 4.56 | % | 2,728 |   | 12 |   | 1.75 | % |
| Securities  available-for-sale                                                                 |       | 53,050                      |       | 494 |   | 3.72 | % | 49,183 |   | 365 |   | 2.97 | % |
| Securities  held-to-maturity                                                                   |       | 2,954                       |       | 29 |   | 3.93 | % | 3,927 |   | 38 |   | 3.87 | % |
| Loans receivable  (1) (2)                                                                 |       | 315,735                     |       | 6,194 |   | 7.78 | % | 297,602 |   | 5,067 |   | 6.77 | % |
| Total interest earning assets                                                                  |       | 375,343                     |       | 6,754 |   | 7.14 | % | 354,998 |   | 5,487 |   | 6.15 | % |
|                                                                                           |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest  earning assets:                                                                   |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks - demand                                                               |       | 15,196                      |       |   |   |   |   | 22,314 |   |   |   |   |   |
| Other assets                                                                                   |       | 20,428                      |       |   |   |   |   | 21,694 |   |   |   |   |   |
| Allowance for credit losses and net unrealized gain  on sales of securities available-for-sale |       | (5,395                      | )          |   |   |   |   | (3,891 | ) |   |   |   |   |
| Total assets                                                                                   |       | $                           | 405,572    |   |   |   |   |   | $ | 395,115 |   |   |   |   |   |
|                                                                                           |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Liabilities and  shareholders’ equity:                                                    |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  deposits:                                                                    |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Demand                                                                                         |       | $                           | 34,483     |   | 46 |   | 0.53 | % | $ | 31,827 |   | 19 |   | 0.24 | % |
| Money market and savings                                                                       |       | 101,809                     |       | 350 |   | 1.36 | % | 112,114 |   | 195 |   | 0.69 | % |
| Time certificates of deposit:                                                                  |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| $100,000 or more                                                                               |       | 51,794                      |       | 323 |   | 2.47 | % | 25,371 |   | 93 |   | 1.46 | % |
| Under $100,000                                                                                 |       | 24,873                      |       | 161 |   | 2.57 | % | 27,479 |   | 121 |   | 1.75 | % |
| Total time certificates of deposit                                                             |       | 76,667                      |       | 484 |   | 2.50 | % | 52,850 |   | 214 |   | 1.61 | % |
| Total interest-bearing deposits                                                                |       | 212,959                     |       | 880 |   | 1.64 | % | 196,791 |   | 428 |   | 0.87 | % |
| Other borrowings                                                                               |       | 9,912                       |       | 92 |   | 3.68 | % | 22,982 |   | 105 |   | 1.82 | % |
| Junior  subordinated debentures                                                                |       | 15,464                      |       | 326 |   | 8.36 | % | 15,464 |   | 259 |   | 6.66 | % |
| Federal funds purchased and securities sold under  agreements to repurchase                    |       | —                      |       | — |   | — |   | — |   | — |   | — |   |
| Total interest-bearing liabilities                                                             |       | 238,335                     |       | 1,298 |   | 2.16 | % | 235,237 |   | 792 |   | 1.34 | % |
|                                                                                           |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  liabilities:                                                              |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing demand deposits                                                            |       | 128,523                     |       |   |   |   |   | 125,857 |   |   |   |   |   |
| Other liabilities                                                                              |       | 1,363                       |       |   |   |   |   | 969 |   |   |   |   |   |
| Shareholders’  equity                                                                     |       | 37,351                      |       |   |   |   |   | 33,052 |   |   |   |   |   |
| Total liabilities and shareholders’ equity                                                |       | $                           | 405,572    |   |   |   |   |   | $ | 395,115 |   |   |   |   |   |
|                                                                                           |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Net interest  income (spread)                                                                  |       |                        |       | $ | 5,456 |   | 4.98 | % |   |   | $ | 4,695 |   | 4.81 | % |
|                                                                                           |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Net yield on earning assets (2)                                                                |       |                        |       |   |   | 5.77 | % |   |   |   |   | 5.26 | % |
|                                                                                                |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

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

(2) Yieldsand amounts earned on loans receivable include loan fees of $421,000 and$484,000 for the three months ended September 30, 2005 and 2004,respectively.

 

The following tablepresents the components of net interest income for the nine months ended September 30,2005 and 2004.

 

20

----

 

 

**Average Balance Sheetand**

**Analysis of NetInterest Income**

 
| ** **                                                                                      | ** ** | **Nine Months ended**      | ** ** |
|-------------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                      | ** ** | **September 30, 2005**     | ** ** | **September 30, 2004** | ** ** |
| ** **                                                                                      | ** ** | ** **                 | ** ** | ** ** | ** ** | **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 purchased under agreements to resell                         |       | $                          | 1,932      |   | 43 |   | 2.98 | % | $ | 7,823 |   | 59 |   | 1.01 | % |
| Due from banks-interest bearing                                                                 |       | 2,250                      |       | 57 |   | 3.39 | % | 3,835 |   | 40 |   | 1.39 | % |
| Securities available-for-sale                                                                   |       | 44,446                     |       | 1,174 |   | 3.52 | % | 42,889 |   | 955 |   | 2.97 | % |
| Securities held-to-maturity                                                                     |       | 3,186                      |       | 94 |   | 3.93 | % | 4,226 |   | 118 |   | 3.72 | % |
| Loans receivable (1) (2)                                                                        |       | 308,986                    |       | 17,312 |   | 7.49 | % | 276,845 |   | 12,772 |   | 6.16 | % |
| Total interest  earning assets                                                                  |       | 360,800                    |       | 18,680 |   | 6.92 | % | 335,618 |   | 13,944 |   | 5.55 | % |
|                                                                                            |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest earning assets:                                                                     |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Cash and due  from banks - demand                                                               |       | 16,880                     |       |   |   |   |   | 22,822 |   |   |   |   |   |
| Other assets                                                                                    |       | 20,628                     |       |   |   |   |   | 21,661 |   |   |   |   |   |
| Allowance for  credit losses and net unrealized gain on sales of securities  available-for-sale |       | (4,611                     | )          |   |   |   |   | (3,705 | ) |   |   |   |   |
| Total assets                                                                                    |       | $                          | 393,697    |   |   |   |   |   | $ | 376,396 |   |   |   |   |   |
|                                                                                            |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Liabilities and shareholders’ equity:                                                      |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing deposits:                                                                      |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Demand                                                                                          |       | $                          | 32,471     |   | 113 |   | 0.47 | % | $ | 31,395 |   | 55 |   | 0.23 | % |
| Money market and  savings                                                                       |       | 100,814                    |       | 804 |   | 1.07 | % | 108,580 |   | 541 |   | 0.67 | % |
| Time  certificates of deposit:                                                                  |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| $100,000 or more                                                                                |       | 45,885                     |       | 790 |   | 2.30 | % | 23,867 |   | 250 |   | 1.40 | % |
| Under $100,000                                                                                  |       | 25,914                     |       | 455 |   | 2.35 | % | 26,611 |   | 339 |   | 1.70 | % |
| Total time  certificates of deposit                                                             |       | 71,799                     |       | 1,245 |   | 2.32 | % | 50,478 |   | 589 |   | 1.56 | % |
| Total  interest-bearing deposits                                                                |       | 205,084                    |       | 2,162 |   | 1.41 | % | 190,453 |   | 1,185 |   | 0.83 | % |
| Other borrowings                                                                                |       | 10,132                     |       | 225 |   | 2.97 | % | 13,703 |   | 277 |   | 2.70 | % |
| Junior subordinated debentures                                                                  |       | 15,464                     |       | 903 |   | 7.81 | % | 15,464 |   | 713 |   | 6.16 | % |
| Federal funds  purchased and securities sold under agreements to repurchase                     |       | —                     |       | — |   | — |   | 94 |   | 1 |   | 1.42 | % |
| Total  interest-bearing liabilities                                                             |       | 230,680                    |       | 3,290 |   | 1.91 | % | 219,714 |   | 2,176 |   | 1.32 | % |
|                                                                                            |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing liabilities:                                                                |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  demand deposits                                                            |       | 125,469                    |       |   |   |   |   | 123,272 |   |   |   |   |   |
| Other  liabilities                                                                              |       | 1,404                      |       |   |   |   |   | 888 |   |   |   |   |   |
| Shareholders’ equity                                                                       |       | 36,144                     |       |   |   |   |   | 32,522 |   |   |   |   |   |
| Total  liabilities and shareholders’ equity                                                |       | $                          | 393,697    |   |   |   |   |   | $ | 376,396 |   |   |   |   |   |
|                                                                                            |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income (spread)                                                                    |       |                       |       | $ | 15,390 |   | 5.01 | % |   |   | $ | 11,768 |   | 4.23 | % |
|                                                                                            |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Net yield on  earning assets (2)                                                                |       |                       |       |   |   | 5.70 | % |   |   |   |   | 4.68 | % |
|                                                                                                 |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

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

(2) Yields and amounts earned on loans receivable include loanfees of $1,281,000 and $1,052,000 for the six months ended September 30, 2005and 2004, respectively.

 

21

----

 

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

 

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

**Average Volume andAverage Rate (1)**

 
| ** **                                                                  | ** ** | **Nine Months ended September 30,  2005 vs 2004** | ** ** |
|-----------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                  | ** ** | **Increase (decrease) due to:**                   | ** ** | **Net  Increase** | ** ** |
| ** **                                                                  | ** ** | **Volume**                                        | ** ** | **Rate** | ** ** | **(Decrease)** | ** ** |
|                                                                        |       |                                              |       |   |   |   |   |
| Interest Income:                                                            |       |                                              |       |   |   |   |   |
| Federal funds  sold and securities purchased under agreement to resell      |       | $                                                 | (44        | ) | $ | 28 |   | $ | (16 | ) |
| Interest-bearing  deposits with other financial institutions                |       | (17                                               | )          | 34 |   | 17 |   |
| Securities  available-for-sale                                              |       | 34                                                |       | 185 |   | 219 |   |
| Securities  held-to-maturity                                                |       | (29                                               | )          | 5 |   | (24 | ) |
| Loans receivable  (2)                                                       |       | 1,482                                             |       | 3,058 |   | 4,540 |   |
| Total  interest-earning assets                                              |       | 1,426                                             |       | 3,310 |   | 4,736 |   |
|                                                                        |       |                                              |       |   |   |   |   |
| Interest Expense:                                                           |       |                                              |       |   |   |   |   |
| Interest-bearing  deposits:                                                 |       |                                              |       |   |   |   |   |
| Demand                                                                      |       | $                                                 | 2          |   | $ | 56 |   | $ | 58 |   |
| Money market and  savings                                                   |       | (39                                               | )          | 302 |   | 263 |   |
| Time  certificates of deposit:                                              |       |                                              |       |   |   |   |   |
| $100,000 or more                                                            |       | 230                                               |       | 310 |   | 540 |   |
| Under $100,000                                                              |       | (9                                                | )          | 125 |   | 116 |   |
| Total time  certificates of deposit                                         |       | 221                                               |       | 435 |   | 656 |   |
| Total  interest-bearing deposits                                            |       | 184                                               |       | 793 |   | 977 |   |
| Other borrowings                                                            |       | (72                                               | )          | 20 |   | (52 | ) |
| Junior  subordinated debentures                                             |       | —                                            |       | 190 |   | 190 |   |
| Federal funds  purchased and securities sold under agreements to repurchase |       | (1                                                | )          | — |   | (1 | ) |
| Total  interest-bearing liabilities                                         |       | 111                                               |       | 1,003 |   | 1,114 |   |
|                                                                        |       |                                              |       |   |   |   |   |
| Net interest income                                                         |       | $                                                 | 1,315      |   | $ | 2,307 |   | $ | 3,622 |   |

 

----

| (1) | The change  in interest income or interest expense that is attributable to both changes  in average balance and average rate has been allocated to the changes due to  (i) average balance and (ii) average rate in proportion to the relationship  of the absolute amounts of changes in each. |
|-----|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | Table does  not include interest income that would have been earned on nonaccrual loans.                                                                                                                                                                                                        |

 

22

----

 

PROVISION FOR CREDIT LOSSES

 

The Company recorded a benefit for credit losses of $213,000for the third quarter 2005.  During thethird quarter 2005, the Company recovered $1.1 million of a loan charged off ina previous period.  Management’sassessment of the adequacy of the allowance for credit losses at September 30,2005 determined that recognition of a benefit was required.  Consequently, a benefit of $124,000 wasreported for the nine months ended September 30, 2005 compared to $120,000provision for the three months and nine months ended September 30, 2004.  See Note 4 of Notes to Consolidated FinancialStatements.

 

OTHER OPERATING INCOME

 

Other operating income decreased to $278,000 duringthe third quarter of 2005 from $317,000 during the third quarter of 2004primarily due to a $122,000 decrease in deposit-related and other customerservices income resulting from changes in deposit fee structures to bundleservices.

 

Other operating income decreased to $899,000 duringthe nine months ended September 30, 2005 from $1.2 million during the ninemonths ended September 30, 2004 primarily due to a $358,000 decrease indeposit-related and other customer services income resulting from changes indeposit fee structures.

 

OTHER OPERATING EXPENSES

 

Other operating expenses increased to$3.7 million for the three months ended September 30, 2005 compared to $3.4million for the same period of 2004. Variances within operating expenseswere: (i) salaries and related benefits expense increased $114,000 or 6.1% dueto the addition of business development staff and increased commission expense;(ii) furniture and equipment expense increased $36,000 or 39.6% due to anincrease in rental equipment and an increase in depreciation expense of fixedassets purchased; (iii) legal services expense increased $80,000 or 150.9% primarilydue to activity on the settlement of a dispute over collateral securing a loan thathas now been resolved; (iv) other professional services expense increased $61,000or 27.0% due to increased costs for audit services; and, (v) other expensesincreased $116,000 or 74.4% due to operating loss accruals.

 

Other operating expenses increased to $10.8 millionfor the nine months ended September 30, 2005 compared to $10.2 million for thesame period of 2004.  Significant varianceswithin operating expenses were: (i) net occupancy expense decreased $143,000 or16.2% due to a reduction in rent from the relocation of the Company’sheadquarters office and banking office in Century City; (ii) legal servicesexpense increased $355,000 or 151.7% primarily due to activity on thesettlement of a

 

23

----

 

dispute overcollateral securing a loan; (iii) other professional services expense increased$227,000 or 37.9% due to a productivity consultant engagement and increasedcosts for audit services; and (v) other expenses increased $207,000 or 55.2%due to operating loss accruals.

 

***BALANCE SHEET ANALYSIS***

 

INVESTMENTSECURITIES

 

Thefollowing comparative period-end table sets forth certain informationconcerning the estimated fair values and

unrealizedgains and losses of securities available-for-sale and securitiesheld-to-maturity.

 

24

----

 

**Estimated Fair Valuesof and Unrealized**

**Gains and Losses onSecurities**

 
| ** **                                                                | ** ** | **September 30, 2005**           | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                | ** ** | **Total**                        | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                                                                | ** ** | **amortized**                    | ** ** | **unrealized** | ** ** | **unrealized** | ** ** | **fair** | ** ** |
| ** **                                                                | ** ** | **cost**                         | ** ** | **gains** | ** ** | **loss** | ** ** | **value** | ** ** |
| ** **                                                                | ** ** | ** (Dollars in thousands)** | ** ** |
| **Available-for-Sale:**                                                   | ** ** | ** **                       | ** ** |
| U.S. Treasury securities                                                  |       | $                                | 699        |   | $ | — |   | $ | 1 |   | $ | 698 |   |
| GNMA-issued/guaranteed  mortgage pass through certificates                |       | 109                              |       | 3 |   | — |   | 112 |   |
| Other U.S.  Government and federal agency securities                      |       | 22,944                           |       | — |   | 152 |   | 22,792 |   |
| FHLMC/FNMA-issued  mortgage pass through certificates                     |       | 17,743                           |       | 24 |   | 148 |   | 17,619 |   |
| CMO’s and  REMIC’s issued by U.S. government-sponsored agencies |       | 29                               |       | — |   | — |   | 29 |   |
| Privately issued  corporate bonds, CMO and REMIC securities               |       | 15,239                           |       | — |   | 107 |   | 15,132 |   |
|                                                                      |       | $                                | 56,763     |   | $ | 27 |   | $ | 408 |   | $ | 56,382 |   |
|                                                                      |       |                             |       |   |   |   |   |   |   |
| FRB and other equity stocks                                               |       | $                                | 3,301      |   | — |   | — |   | $ | 3,301 |   |

 
| ** **                                            | ** ** | **September 30, 2005**     | ** ** |
|-------------------------------------------------------|------------|----------------------------|------------|
| ** **                                            | ** ** | **Total**                  | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                                            | ** ** | **Amortized**              | ** ** | **unrealized** | ** ** | **unrealized** | ** ** | **fair** | ** ** |
| ** **                                            | ** ** | **Cost**                   | ** ** | **gains** | ** ** | **loss** | ** ** | **value** | ** ** |
| ** **                                            | ** ** | **(Dollars in thousands)** | ** ** |
| **Held-to-Maturity:**                                 |       |                       |       |   |   |   |   |   |   |
| FHLMC/FNMA-issued  mortgage pass through certificates |       | $                          | 2,795      |   | $ | — |   | $ | 32 |   | $ | 2,763 |   |
|                                                  |       |                       |       |   |   |   |   |   |   |
|                                                  |       | $                          | 2,795      |   | $ | — |   | $ | 32 |   | $ | 2,763 |   |

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

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

 

25

----

 

As of September 30, 2005, the Companydid not hold securities of any issuer, other than U.S. government-charteredagencies, the aggregate book value of which exceeded 10% of the Company’sshareholders’ equity.  At September 30,2005 and December 31, 2004, there were no securities deemed by management to beother-than-temporarily impaired.

 

LOANPORTFOLIO

 

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

 

**Loan Portfolio Composition**

 
| ** **                                                            | ** ** | **September 30,  2005**    | ** ** | **December 31,  2004** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------|------------|------------------------|------------|
| ** **                                                            | ** ** | **Amount**                 | ** ** | **Percent**            | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **                                                            | ** ** | **(Dollars in thousands)** | ** ** |
| Commercial loans - secured and unsecured                              |       | $                          | 88,281     |                   | 27         | % | $ | 98,429 |   | 31 | % |
| Real estate loans:                                                    |       |                       |       |                   |       |   |   |   |   |
| Secured by  commercial real properties                                |       | 128,555                    |       | 39                     | %          | 135,944 |   | 43 | % |
| Secured by one to  four family residential properties                 |       | 11,697                     |       | 3                      | %          | 9,405 |   | 3 | % |
| Secured by  multifamily residential properties                        |       | 18,891                     |       | 6                      | %          | 18,330 |   | 6 | % |
| Total real  estate loans                                              |       | 159,143                    |       | 48                     | %          | 163,679 |   | 52 | % |
| Construction and land development                                     |       | 79,097                     |       | 24                     | %          | 50,289 |   | 16 | % |
| Consumer  installment, home equity and unsecured loans to individuals |       | 4,786                      |       | 1                      | %          | 2,516 |   | 1 | % |
| Total loans  outstanding                                              |       | 331,307                    |       | 100                    | %          | 314,913 |   | 100 | % |
|                                                                  |       |                       |       |                   |       |   |   |   |   |
| Deferred net loan origination fees                                    |       | (1,128                     | )          |                   |       | (1,066 | ) |   |   |
| Loans receivable, net                                                 |       | $                          | 330,179    |                   |       |   | $ | 313,847 |   |   |   |

 

Total loans outstanding increased by $16.3 million to$330.2 million at September 30, 2005 compared to $313.8 million at December 31,2004 due primarily to increased funding of construction loans.  The growth in construction loans was offsetby a $10.1 million decline in commercial loans and a $7.4 million decline inreal estate loans secured by commercial real properties.  The first half of 2005 experienced a declinein loan volume largely due to the payoff of construction loans for completedreal estate projects and the lack of construction loan funding for new projectsdelayed by an unusually rainy winter and spring in

 

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SouthernCalifornia.  Construction loan fundingincreased in the third quarter 2005 as the projects moved forward.  The decrease in commercial loans andcommercial real estate loans occurred primarily in the first half of 2005, whenborrowers concerned about rising rates increasingly refinanced their adjustablerate loans into fixed rate loans.  TheCompany suffered a net outflow of these loans as competitors were willing to pricethe fixed rate loans at lower interest rates than the Company was willing tooffer.  The refinancing activitymoderated during the third quarter. Throughout 2005, the Company’s borrowers have been repaying commercialloans and reducing the utilization of credit commitments.

 

NONPERFORMINGASSETS

 

The following comparative period-end table sets forthcertain information concerning nonperforming assets.

 

**Nonperforming Assets**

 
| ** **                                                                                                                  | ** ** | **September 30,**          | ** ** | **December 31** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|-----------------|------------|
| ** **                                                                                                                  | ** ** | **2005**                   | ** ** | **2004**        | ** ** |
| ** **                                                                                                                  | ** ** | **(Dollars in thousands)** | ** ** |
|                                                                                                                        |       |                       |       |            |       |
| Nonaccrual loans                                                                                                            |       | $                          | 313        |            | $          | 18 |   |
| Troubled debt restructurings                                                                                                |       | —                     |       | —          |       |
| Loans  contractually past due ninety or more days with respect to either principal  or interest and still accruing interest |       | —                     |       | 1,804           |       |
| Nonperforming loans                                                                                                         |       | 313                        |       | 1,822           |       |
| Other real estate owned                                                                                                     |       | 1,056                      |       | 1,056           |       |
| Other nonperforming assets                                                                                                  |       | —                     |       | —          |       |
| Total nonperforming assets                                                                                                  |       | $                          | 1,369      |            | $          | 2,878 |   |
|                                                                                                                        |       |                       |       |            |       |
| Allowance for credit losses as a percent of  nonaccrual loans                                                               |       | 1446.0                     | %          | 21822.2         | %          |
| Allowance for credit losses as a percent of  nonperforming loans                                                            |       | 1446.0                     | %          | 215.6           | %          |
| Total nonperforming assets as a percent of loans  receivable                                                                |       | 0.4                        | %          | 0.9             | %          |
| Total nonperforming assets as a percent of total  shareholders’ equity                                                 |       | 3.7                        | %          | 8.3             | %          |

 

ALLOWANCE FOR CREDIT LOSSES

 

The adequacy of the allowance for credit losses isdetermined through periodic analysis of the loan portfolio.  This analysis includes a systematic anddetailed review of the classification and categorization of problem loans; anassessment of the overall quality and collectibility of the portfolio; andconsideration of the loan loss experience, trends in problem loans,concentrations of credit risk, as well as current economic conditions(particularly Southern California). During the third quarter 2005, Management modified the methodology forevaluating the adequacy of the allowance for credit losses to (i)

 

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conform theanalyses between the Banks, (ii) recognize a factor for probable losses in theCompany’s adjustable rate loans resulting from increasing borrower difficultyto service debt in a rising interest rate environment, and (iii) recognize afactor for greater probable losses in certain higher risk loan segmentsincluding film production finance and consumer overdrafts.  The supplemental factors resulted in $571,000additional allowance for credit losses. Management performs a periodic risk and credit analysis, the results ofwhich are reported to the Board of Directors.

 

There were no loans charged off during the thirdquarter of 2005.  Loans charged offduring the nine months ended September 30, 2005 were $6,000.  This compares to no loans being charged off duringthe third quarter of 2004 and $35,000 during the first nine months of2004.  Recoveries of loans previouslycharged off were $1.1 million and $1.2 million during the third quarter and firstnine months of 2005, respectively, compared to $39,000 and $130,000 during the thirdquarter and first nine months of 2004.  Pursuantto Management’s evaluation of the allowance for credit losses at September 30,2005, a benefit for credit losses of $213,000 was recorded for the thirdquarter 2005.  See Note 4 of Notes toConsolidated Financial Statements.

 

Credit quality is affected by many factors beyond thecontrol of the Company, including local and national economies, and facts mayexist which are not known to the Company that adversely affect the likelihoodof repayment of various loans in the loan portfolio and realization ofcollateral upon a default. Accordingly, no assurance can be given that theCompany will not sustain loan losses materially in excess of the allowance forcredit losses. In addition, the Office of the Comptroller of the Currency (“OCC”),as an integral part of its examination process, periodically reviews theallowance for credit losses and could require additional provisions for creditlosses.

 

DEPOSITS

 

Total deposits were $354.6 million and $313.5 millionat September 30, 2005 and December 31, 2004, respectively.  Noninterest-bearing demand deposits increasedto $124.1 million at September 30, 2005 compared to $113.9 million at December31, 2004.  Our noninterest-bearing demanddeposits experience significant variability and seasonality due to the natureof our depositors’ businesses and the cash needs of our business customers forquarterly tax payments and owner distributions. Noninterest-bearing demand deposits declined significantly at December31, 2004 from the fourth quarter average of $129.0 million; thus the increaseat September 30, 2005 reflected a normalization following this year-endvariability.  Money market deposits andsavings deposits were $75.4 million and $30.2 million, respectively, at September30, 2005 compared to $69.4 million and $32.2 million, respectively, at December31, 2004.  Interest-bearing demanddeposits,

 

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which for the mostpart are limited to individuals, decreased to $31.6 million at September 30,2005 from $35.0 million at December 31, 2004. Interest-bearing demand deposits increased significantly at December 31,2004 from the fourth quarter average of $31.7 million, thus the decline at September30, 2005 reflected a normalization following the year-end variability.  Time certificates of deposit (“TCDs”)increased to $93.4 million at September 30, 2005 from $63.1 million at December31, 2004 due to an increase in brokered deposits.  There were $27.5 million in brokered TCDs at September30, 2005 compared to $6.9 million at December 31, 2004.

 

During the first nine months of 2005, the Companysupplemented its liquidity by increasing its use of brokers to issuethree-month to one-year TCDs.  Theseefforts resulted in a net increase of brokered TCDs of $20.6 million from $6.9million at December 31, 2004 to $27.5 million at September 30, 2005.

 

Additionally, although the Company has priced itsretail certificates of deposit to encourage runoff during the past severalyears, in the rising rate environment experienced during the first three quartersof 2005, it has elected to only moderately increase rates on its immediatelyrepriceable base of deposits – interest-bearing demand deposits, and savingsand money market deposits – and price new time certificates of deposit togenerate growth.

 

In a sustained rising interest rate environment,increases in deposit interest rates will be required to prevent net depositwithdrawals.  Additionally, in order togenerate new deposit growth, the Company has paid significantly higher ratesthan that paid on existing deposits.

 

OTHERBORROWINGS

 

Therewere $19.0 million of other borrowings, consisting of advances from the FederalHome Loan Bank, at September 30, 2005 compared to $25.9 million at December 31,2004.  The decline in other borrowingsreflected repayment at maturity due to the increase in deposits, partiallyoffset by the increase in loan fundings and security purchases.

 

SHAREHOLDERS’EQUITY

 

Shareholders’ equity increased from $34.5 million atDecember 31, 2004 to $37.1 million at September 30, 2005 due to the retainedearnings for the nine months ended September 30, 2005 partially offset by a decreasein market value of interest rate swaps and securities available-for-sale.

 

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***CAPITAL ADEQUACY REQUIREMENTS***

 

At September 30, 2005, National Mercantile and theBanks were in compliance with all applicable regulatory capital requirementsand the Banks were “well capitalized” under the Prompt Corrective Action rulesof the OCC.  The following table setsforth the regulatory capital standards for well-capitalized institutions, andthe capital ratios for National Mercantile and the Banks, as of September 30,2005 and December 31, 2004.

 

**Regulatory CapitalInformation**

**of the NationalMercantile Bancorp and Banks**

 
| ** **                       | ** ** | **Minimum**     | ** ** | ** **      | ** ** | ** **        | ** ** | ** **       | ** ** |
|----------------------------------|------------|-----------------|------------|-----------------|------------|-------------------|------------|------------------|------------|
| ** **                       | ** ** | **For Capital** | ** ** | **Well**        | ** ** | ** **        | ** ** | ** **       | ** ** |
| ** **                       | ** ** | **Adequacy**    | ** ** | **Capitalized** | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                       | ** ** | **Purposes**    | ** ** | **Standards**   | ** ** | **2005**          | ** ** | **2004**         | ** ** |
| **National Mercantile Bancorp:** |       |            |       |            |       |              |       |             |       |
| Tier 1 leverage                  |       | 4.00            | %          | N/A             |       | 11.04             | %          | 9.87             | %          |
| Tier 1 risk-based capital        |       | 4.00            | %          | N/A             |       | 11.72             | %          | 10.39            | %          |
| Total risk-based capital         |       | 8.00            | %          | N/A             |       | 13.67             | %          | 12.42            | %          |
|                             |       |            |       |            |       |              |       |             |       |
| **Mercantile National Bank:**    |       |            |       |            |       |              |       |             |       |
| Tier 1 leverage                  |       | 4.00            | %          | 5.00            | %          | 11.01             | %          | 8.99             | %          |
| Tier 1 risk-based capital        |       | 4.00            | %          | 6.00            | %          | 13.40             | %          | 10.44            | %          |
| Total risk-based capital         |       | 8.00            | %          | 10.00           | %          | 14.66             | %          | 11.60            | %          |
|                             |       |            |       |            |       |              |       |             |       |
| **South Bay Bank, NA:**          |       |            |       |            |       |              |       |             |       |
| Tier 1 leverage                  |       | 4.00            | %          | 5.00            | %          | 9.69              | %          | 9.32             | %          |
| Tier 1 risk-based capital        |       | 4.00            | %          | 6.00            | %          | 8.93              | %          | 9.32             | %          |
| Total risk-based capital         |       | 8.00            | %          | 10.00           | %          | 10.18             | %          | 10.29            | %          |

 

***LIQUIDITY***

 

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

 

The Company’s cash anddue from banks - demand was $15.1 million on September 30, 2005 compared to$14.2 million on December 31, 2004.  Duefrom banks-interest-bearing was $2.0 million at September 30, 2005 and $2.7million at December 31, 2004, respectively. There was $3.1 million in Federal funds sold at September 30, 2005 comparedto no Federal funds sold at December 31, 2004. Mercantile had $5.0 million and South Bay had $12.0 million in Federalfunds lines with correspondent banks as of September 30, 2005.

 

National Mercantile is a legal entity separate anddistinct from the Banks and, therefore, it must provide for its own liquidity.  National Mercantile’s principal sources offunds are proceeds from the sales of securities and dividends or capital

 

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distributions fromthe Banks.  In addition to funding itsown operating expenses, National Mercantile is responsible for the payment ofthe interest on the outstanding Junior Subordinated Debentures.  The semiannual interest payments on theJunior Subordinated Debentures are deferrable at National Mercantile’s option,for a period up to ten consecutive semiannual payments, but in any event notbeyond June 25, 2031.  NationalMercantile has not deferred any interest payments.

 

National Mercantile’s cash and due from banks was $32,000on September 30, 2005 compared to $174,000 at December 31, 2004.  Due from banks-interest bearing was $1.0million at September 30, 2005 compared to $1.7 million at December 31, 2004.

 

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

 

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

 

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

 

Mercantile has asubstantial accumulated deficit and does not anticipate having positivecumulative retained earnings for the foreseeable future.  South Bay had cumulative retained earnings of$2.1 million as of September 30, 2005. 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.

 

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***ASSET LIABILITYMANAGEMENT***

 

The following table shows that the Company’scumulative one-year interest rate sensitivity gap indicated a liabilitysensitive position of $13.9 million at September 30, 2005 compared to aliability sensitive position of $9.2 million at December 31, 2004.  This change resulted primarily from anincrease in securities repricing after three months but within one year, anincrease in federal funds sold and a decrease in other borrowings partiallyoffset by a decrease in adjustable loans receivable and an increase in timecertificates of deposit.

 

Interest rate sensitivity is managed by matching therepricing opportunities on the Company’s earning assets to those on the fundingliabilities.  Various strategies are usedto manage the repricing characteristics of assets and liabilities to ensurethat exposure to interest rate fluctuations is limited within guidelines ofacceptable levels of risk-taking. Hedging strategies, including the terms and pricing of loans anddeposits, the use of derivative financial instruments (see Note 9 to theConsolidated Financial Statements) and managing the deployment of securitiesare used to reduce mismatches in interest rate repricing opportunities ofportfolio assets and their funding sources. Interest rate risk is measured using financial modeling techniques,including stress tests, to measure the impact of changes in interest rates onfuture earnings.  These staticmeasurements do not reflect the results of any projected activity and are bestused as early indicators of potential interest rate exposures.

 

The Company’s interest rate sensitivity positionduring a period of moderate rising interest rates is expected to have a positiveimpact on net interest income due to the Company’s large base ofnoninterest-bearing deposits as well as interest rates paid on fundingliabilities typically change in smaller magnitude compared to changes in theyield 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 declining rates, such as theenvironment that was experienced during 2001 and 2002, the decline is expectedto have a negative effect on the Company’s net interest income as changes inthe rates of interest-bearing deposits historically have not changed in similarmagnitude to changes in market interest rates. Additionally, in relatively low and declining interest rateenvironments, the interest rates paid on funding liabilities may begin to reachfloors preventing further downward adjustments while rates on earning assetscontinue to adjust downward.  Topartially mitigate the negative effects of declining

 

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interest rates onits net interest margin, during the third quarter 2005 the Company acceleratedits purchases of intermediate term investment securities which were partlyfunded 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.

 

**Rate-Sensitive Assetsand Liabilities**

 
| ** **                                                               | ** ** | **September 30, 2005**       | ** ** |
|--------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                               | ** ** | **Maturing or repricing in** | ** ** |
| ** **                                                               | ** ** | **Less**                     | ** ** | **After three** | ** ** | **After one** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                               | ** ** | **than**                     | ** ** | **months** | ** ** | **year** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                               | ** ** | **three**                    | ** ** | **but within** | ** ** | **but within** | ** ** | **After** | ** ** | ** ** | ** ** |
| ** **                                                               | ** ** | **months**                   | ** ** | **one year** | ** ** | **5 years** | ** ** | **5 years** | ** ** | **Total** | ** ** |
| ** **                                                               | ** ** | **(Dollars in thousands)**   | ** ** |
| Rate-Sensitive Assets:                                                   |       |                         |       |   |   |   |   |   |   |   |   |
| Federal funds  sold and securities purchased under agreements to resell  |       | $                            | 3,110      |   | $ | — |   | $ | — |   | $ | — |   | $ | 3,110 |   |
| Securities at amortized cost                                             |       | 422                          |       | 14,643 |   | 11,744 |   | 32,749 |   | 59,558 |   |
| Due from banks - interest bearing                                        |       | 2,000                        |       | — |   | — |   | — |   | 2,000 |   |
| FRB and other stock, at cost                                             |       | —                       |       | — |   | — |   | 3,301 |   | 3,301 |   |
| Loans receivable (1)                                                     |       | 257,739                      |       | 13,416 |   | 41,291 |   | 17,420 |   | 329,866 |   |
| Interest rate swaps                                                      |       | —                       |       | — |   | 50,000 |   | 15,000 |   | 65,000 |   |
| Total  rate-sensitive assets                                             |       | 263,271                      |       | 28,059 |   | 103,035 |   | 68,470 |   | 462,835 |   |
|                                                                     |       |                         |       |   |   |   |   |   |   |   |   |
| Rate-Sensitive Liabilities: (2)                                          |       |                         |       |   |   |   |   |   |   |   |   |
| Interest bearing deposits:                                               |       |                         |       |   |   |   |   |   |   |   |   |
| Demand, money  market and savings                                        |       | 137,140                      |       | — |   | — |   | — |   | 137,140 |   |
| Time  certificates of deposit                                            |       | 32,674                       |       | 51,457 |   | 9,232 |   | — |   | 93,363 |   |
| Other borrowings                                                         |       | 19,000                       |       |   |   |   |   |   |   | 19,000 |   |
| Interest rate swaps                                                      |       | 65,000                       |       | — |   | — |   | — |   | 65,000 |   |
| Total  rate-sensitive liabilities                                        |       | 253,814                      |       | 51,457 |   | 9,232 |   | — |   | 314,503 |   |
| Interest rate-sensitivity gap                                            |       | 9,457                        |       | (23,398 | ) | 93,803 |   | 68,470 |   | 148,332 |   |
| Cumulative interest rate-sensitivity gap                                 |       | $                            | 9,457      |   | $ | (13,941 | ) | $ | 79,862 |   | $ | 148,332 |   |   |   |
| Cumulative ratio  of rate sensitive assets to rate-sensitive liabilities |       | 104                          | %          | 95 | % | 125 | % | 147 | % |   |   |
|                                                                          |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)          Loans receivable excludesnonaccrual loans.

(2)          Deposits which are subject to immediate withdrawal arepresented as repricing within three months or less.

The distribution of other timedeposits is based on scheduled maturities.

 

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**Rate-Sensitive Assetsand Liabilities**

 
| ** **                                                               | ** ** | **December 31, 2004**        | ** ** |
|--------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                               | ** ** | **Maturing or repricing in** | ** ** |
| ** **                                                               | ** ** | **Less**                     | ** ** | **After three** | ** ** | **After one** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                               | ** ** | **than**                     | ** ** | **months** | ** ** | **year** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                               | ** ** | **three**                    | ** ** | **but within** | ** ** | **but within** | ** ** | **After** | ** ** | ** ** | ** ** |
| ** **                                                               | ** ** | **months**                   | ** ** | **one year** | ** ** | **5 years** | ** ** | **5 years** | ** ** | **Total** | ** ** |
| ** **                                                               | ** ** | **(Dollars in thousands)**   | ** ** |
| Rate-Sensitive Assets:                                                   |       |                         |       |   |   |   |   |   |   |   |   |
| Federal funds  sold and securities purchased under agreements to resell  |       | $                            | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Securities  available-for-sale, at amortized cost                        |       | 500                          |       | $ | 6,696 |   | $ | 15,885 |   | $ | 13,939 |   | $ | 37,020 |   |
| Securities held-to-maturity                                              |       | —                       |       | — |   | — |   | 3,507 |   | 3,507 |   |
| Due from banks - interest bearing                                        |       | 2,728                        |       | — |   | — |   |   |   | 2,728 |   |
| FRB and other stock, at cost                                             |       | —                       |       | — |   | — |   | 3,076 |   | 3,076 |   |
| Loans receivable (1)                                                     |       | 251,134                      |       | 10,468 |   | 40,991 |   | 11,236 |   | 313,829 |   |
| Interest rate swaps                                                      |       | —                       |       | — |   | 40,000 |   | 25,000 |   | 65,000 |   |
| Total  rate-sensitive assets                                             |       | 254,362                      |       | 17,164 |   | 96,876 |   | 56,758 |   | 425,160 |   |
|                                                                     |       |                         |       |   |   |   |   |   |   |   |   |
| Rate-Sensitive Liabilities: (2)                                          |       |                         |       |   |   |   |   |   |   |   |   |
| Interest bearing deposits:                                               |       |                         |       |   |   |   |   |   |   |   |   |
| Demand, money  market and savings                                        |       | 136,591                      |       | — |   | — |   | — |   | 136,591 |   |
| Time  certificates of deposit                                            |       | 26,708                       |       | 26,543 |   | 9,848 |   | — |   | 63,099 |   |
| Other borrowings                                                         |       | 25,900                       |       | — |   | — |   | — |   | 25,900 |   |
| Junior subornidated debentures                                           |       | —                       |       | — |   | — |   | 15,464 |   | 15,464 |   |
| Interest rate swaps                                                      |       | 65,000                       |       | — |   | — |   | — |   | 65,000 |   |
| Total  rate-sensitive liabilities                                        |       | 254,199                      |       | 26,543 |   | 9,848 |   | 15,464 |   | 306,054 |   |
| Interest rate-sensitivity gap                                            |       | 163                          |       | (9,379 | ) | 87,028 |   | 41,294 |   | 119,106 |   |
| Cumulative interest rate-sensitivity gap                                 |       | $                            | 163        |   | $ | (9,216 | ) | $ | 77,812 |   | $ | 119,106 |   |   |   |
| Cumulative ratio  of rate sensitive assets to rate-sensitive liabilities |       | 100                          | %          | 97 | % | 127 | % | 139 | % |   |   |

 

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(1)          Loans receivable excludesnonaccrual loans.

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

The distribution of other timedeposits is based on scheduled maturities.

 

# **FACTORS WHICH MAY AFFECT FUTURE OPERATING RESULTS**

 

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

 

**Risk fromchanges in interest rates.**

 

The success of the Company’s business depends, to alarge extent, on its net interest income. Changes in market interest rates can affect net interest income byaffecting the spread between interest-earning assets and interest-bearingliabilities.  This

 

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may be due to thedifferent maturities of interest-earning assets and interest-bearingliabilities, as well as an increase in the general level of interestrates.  Changes in market interest ratesalso affect, among other things:

 

•                  The Company’sability to originate loans;

 

•                  The abilityof borrowers to make payments on their loans;

 

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

 

•                  The averagelife of interest-earning assets;

 

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

 

•                  The abilityto access the wholesale funding market.

 

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

 

**Risk frompossible declines in the quality of the Company’s assets.**

 

TheCompany’s financial condition depends significantly on the quality of itsassets.  While its has developed andimplemented underwriting policies and procedures to guide management in themaking of loans, compliance with these policies and procedures in making loansdoes not guarantee repayment of the loans. If the level of non-performing assets rises, the results of operationsand financial condition will be affected. A borrower’s ability to pay its loan in accordance with its terms can beadversely affected by a number of factors, such as a decrease in the borrower’srevenues and cash flows due to adverse changes in economic conditions or adecline in the demand for the borrower’s products and/or services.

 

**Allowancesfor credit losses may be inadequate.**

 

Allowancesfor credit losses are established against each segment of the loanportfolio.  At September 30, 2005, theallowance for credit losses equaled 1.37% of loans receivable and 1382.0% ofnonperforming loans.  Although managementbelieves that it has established adequate allowances for credit losses as of September30, 2005, 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 examinationprocess, 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

 

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increases in the size andchanges in the composition of the loan portfolio.  Increases in the provisions for credit losseswould adversely affect the Company’s results of operations.

 

**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 for itsloans.  In addition, an unfavorableeconomy could reduce the demand for its loans and other products and services.

 

**Because asignificant amount of the loans are made to borrowers in California, theCompany’s operations could suffer as a result of local recession or naturaldisasters in California.**

 

AtSeptember 30, 2005, a large majority of the loans outstanding were collateralizedby real properties located in California. Because of this concentration in California, the Company’s financialposition and results of operations have been and are expected to continue to beinfluenced by general trends in the California economy and its real estatemarket.  Real estate market declines mayadversely affect 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 and erosion-causedmudslides, which are not typically covered by the standard hazard insurancepolicies maintained by borrowers. Uninsured disasters may adversely impact the ability to recover losseson properties affected by such disasters and adversely impact the Company’sresults of operations.

 

**TheCompany’s business is very competitive.**

 

Thereis intense competition in Southern California and elsewhere in the UnitedStates for banking customers.  TheCompany experiences competition for deposits from many sources, includingcredit unions, insurance companies and money market and other mutual funds, aswell as other 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, marketing capabilityand name recognition, and operate on a statewide or nationwide basis.  In addition, recent developments intechnology and mass marketing have permitted larger

 

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companies to market loansmore aggressively to small business customers. Such advantages may give the competitors opportunities to realizegreater efficiencies and economies of scale than the Company can.  There is no assurance that the Company willbe able to compete effectively against its competition.

 

**TheCompany’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 annually andany impairment must be recorded as a charge to earnings**.

 

Statement of Financial Accounting Standards No. 142 “Goodwilland Other Intangible Assets” (“SFAS No. 142”), among other provisions,prescribes that goodwill and intangible assets that have indefinite usefullives will not be amortized but rather tested annually, or more frequently uponthe occurrence of certain events, for impairment.  SFAS No. 142 provides specific guidance forthe testing of goodwill for impairment, which may require re-measurement of thefair value of the reporting unit. Impairment losses are to be reported as a charge to current period earnings.

 

The Company has goodwill of $3.2 million in connectionwith the South Bay acquisition in December 2001.  During the fourth quarter of 2004, therequired impairment tests of goodwill were completed.  The tests determined that goodwill was notconsidered impaired.  No assurance can begiven that goodwill will not become impaired in the future.

 

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

 

Ona periodic basis, at least annually, an analysis is performed to determine ifit is more likely than not that some or all of the gross deferred tax assetwill not be realized.  Factors used inthe analysis that are reflective of the future realization of a deferred taxasset 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 to reduce thedeferred tax asset to its realizable value. The determination of whether a valuation allowance is necessary involvesconsidering the positive and negative factors related to whether the deferredtax

 

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asset is more likely than not to be realized.  Any adjustment required to the valuationallowance 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 September30, 2005.

 

CAUTIONARYNOTE REGARDING FORWARD-LOOKING STATEMENTS

 

Thisreport contains forward-looking statements about the Company.  Forward-looking statements consist ofdescription of plans or objectives for future operations, products or services,forecasts of revenues, earnings or other measures of economic performance andassumptions underlying or relating to any of the foregoing.  Because forward-looking statements discussfuture events or conditions and not historical facts, they often include wordssuch as “anticipate,” “believe,” “estimate,” “expect,” “intend,” “plan,” “project,”“target,” “can,” “could,” “may,” “should” or similar expressions.  Do not rely unduly on forward-lookingstatements.  They give the Company’sexpectations about the future and are not guarantees or predictions of futuresevents, conditions or results. Forward-looking statements speak only as of the date they are made, andthe Company does not undertake to update them to reflect changes that occurafter that date.

 

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

 

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

 

The Company maintains disclosure controls andprocedures (as defined in Exchange Act Rule 13a-15(e)) that are designed toassure that information required to be disclosed in its Exchange Act reports isrecorded, processed, summarized and reported within the time periods specifiedin the Securities and Exchange Commission’s rules and forms, and that suchinformation is accumulated and communicated to management, including the ChiefExecutive Officer and Chief Financial Officer, as appropriate, to allow timelydecisions regarding required disclosures.

 

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In designing and evaluating the disclosure controlsand procedures, management recognizes that any controls and procedures, nomatter how well designed and operated, can provide reasonable assurance only ofachieving the desired control objectives, and management necessarily isrequired to apply its judgment in weighting the costs and benefits of possiblenew or different controls and procedures. Limitations are inherent in all control sysytems, so no evaluation ofcontrols can provide absolute assurance that all control issues and any fraudwithin the company have been detected.

 

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

 

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

 

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**PART II—OTHERINFORMATION**

 

***Item 1.***                      LEGAL PROCEEDINGS

 

None.

 

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

 

None.

 

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

 

None.

 

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

*** ***

None.

 

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

 

None.

 

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

 

31.1 Certification of Scott A. Montgomery on disclosurecontrols

31.2 Certification of David R. Brown on disclosure controls

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

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

 

**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 

 
|   |               | **NATIONAL MERCANTILE BANCORP**                       | ** **                           |   |
|--------|--------------------|-------------------------------------------------------|--------------------------------------|--------|
|   |               | (Registrant)                                          |                                 |
|   |               |                                                  |                                 |
| DATE:  | November  10, 2005 |                                                  | /s/    Scott A. Montgomery |   |
|   |               |                                                  | **Scott A.  Montgomery**             |   |
|   |               |                                                  | Chief  Executive Officer             |   |
|   |               |                                                  |                                 |   |
| DATE:  | November  10, 2005 |                                                  | /s/    David R. Brown      |   |
|   |               | **David R. Brown**                                    |                                 |
|   |               | Principal  Financial and Principal Accounting Officer |                                 |

 

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