**UNITED STATES****SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

----

 

**Form 10-QSB**

 

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

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

 

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

**for the transition period from             to             .**

 

**Commission File Number 0-15982**

 

**NATIONAL MERCANTILE BANCORP**

(Exact name of small business issuer in its charter)

 

| **California**                                                          | ** ** | **95-3819685**                       |
|-------------------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of 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

 

The number of shares ofCommon Stock, no par value, of the issuer outstanding as of August 12,2005 was 4,322,674.

 

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

 

 

----

 

PART I – FINANCIAL INFORMATION

 

*Item 1. Financial Statements*

 

**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

(Unaudited)

 
| ** **                                                                                                                                                                                                         | ** ** | **June 30,**          | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                         | ** ** | **2005**                   | ** ** | **2004**              | ** ** |
| ** **                                                                                                                                                                                                         | ** ** | **(Dollars in thousands)** | ** ** |
| ASSETS                                                                                                                                                                                                             |       |                       |       |                  |       |
| Cash and due from banks-demand                                                                                                                                                                                     |       | $                          | 19,294     |                  | $          | 14,187 |   |
| Due from banks-interest bearing                                                                                                                                                                                    |       | 2,000                      |       | 2,728                 |       |
| Federal funds sold and securities purchased under  agreements to resell                                                                                                                                            |       | 9,000                      |       | —                |       |
| Cash and cash equivalents                                                                                                                                                                                          |       | 30,294                     |       | 16,915                |       |
| Securities available-for-sale, at fair value;  aggregate amortized cost of $43,387 and $37,020 at June 30, 2005 and December 31,  2004, respectively                                                     |       | 43,287                     |       | 36,954                |       |
| Securities held-to-maturity, at amortized cost                                                                                                                                                                     |       | 3,048                      |       | 3,507                 |       |
| FRB and other stock, at cost                                                                                                                                                                                       |       | 3,163                      |       | 3,076                 |       |
| Loans receivable                                                                                                                                                                                                   |       | 307,528                    |       | 313,847               |       |
| Allowance for credit losses                                                                                                                                                                                        |       | (4,146                     | )          | (3,928                | )          |
| Net loans receivable                                                                                                                                                                                               |       | 303,382                    |       | 309,919               |       |
|                                                                                                                                                                                                               |       |                       |       |                  |       |
| Premises and equipment, net                                                                                                                                                                                        |       | 5,852                      |       | 5,804                 |       |
| Other real estate owned                                                                                                                                                                                            |       | 1,056                      |       | 1,056                 |       |
| Deferred tax asset                                                                                                                                                                                                 |       | 4,862                      |       | 5,286                 |       |
| Goodwill                                                                                                                                                                                                           |       | 3,225                      |       | 3,225                 |       |
| Core deposit intangible, net                                                                                                                                                                                       |       | 1,519                      |       | 1,630                 |       |
| Accrued interest receivable and other assets                                                                                                                                                                       |       | 3,996                      |       | 3,750                 |       |
| Total assets                                                                                                                                                                                                       |       | $                          | 403,684    |                  | $          | 391,122 |   |
|                                                                                                                                                                                                               |       |                       |       |                  |       |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                                                                                                          |       |                       |       |                  |       |
| Deposits:                                                                                                                                                                                                          |       |                       |       |                  |       |
| Noninterest-bearing demand                                                                                                                                                                                         |       | $                          | 145,997    |                  | $          | 113,852 |   |
| Interest-bearing demand                                                                                                                                                                                            |       | 31,284                     |       | 34,961                |       |
| Money market                                                                                                                                                                                                       |       | 65,894                     |       | 69,431                |       |
| Savings                                                                                                                                                                                                            |       | 30,555                     |       | 32,199                |       |
| Time certificates of deposit:                                                                                                                                                                                      |       |                       |       |                  |       |
| $100,000 or more                                                                                                                                                                                                   |       | 56,079                     |       | 41,111                |       |
| Under $100,000                                                                                                                                                                                                     |       | 20,501                     |       | 21,988                |       |
| Total deposits                                                                                                                                                                                                     |       | 350,310                    |       | 313,542               |       |
|                                                                                                                                                                                                               |       |                       |       |                  |       |
| Other borrowings                                                                                                                                                                                                   |       | —                     |       | 25,900                |       |
| Junior subordinated deferrable interest debentures                                                                                                                                                                 |       | 15,464                     |       | 15,464                |       |
| Accrued interest payable and other liabilities                                                                                                                                                                     |       | 1,478                      |       | 1,734                 |       |
| Total liabilities                                                                                                                                                                                                  |       | 367,252                    |       | 356,640               |       |
|                                                                                                                                                                                                               |       |                       |       |                  |       |
| Shareholders’ equity:                                                                                                                                                                                         |       |                       |       |                  |       |
| Preferred stock, no par value - authorized 1,000,000  shares:                                                                                                                                                      |       |                       |       |                  |       |
| Series A non-cumulative convertible perpetual  preferred stock;** **authorized  990,000 shares; no shares and 666,273 shares outstanding at June 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 June 30,  2005 and December 31, 2004                                           |       | 1,000                      |       | 1,000                 |       |
| Common stock, no par value; authorized 10,000,000  shares; 4,320,874 shares and 2,954,128 shares outstanding at June 30,  2005 and December 31, 2004, respectively                                       |       | 45,155                     |       | 39,491                |       |
| Accumulated deficit                                                                                                                                                                                                |       | (9,747                     | )          | (11,726               | )          |
| Accumulated other comprehensive income                                                                                                                                                                             |       | 24                         |       | 275                   |       |
| Total shareholders’ equity                                                                                                                                                                                    |       | 36,432                     |       | 34,482                |       |
| Total liabilities and shareholders’ equity                                                                                                                                                                    |       | $                          | 403,684    |                  | $          | 391,122 |   |

 

See accompanying notes toconsolidated financial statements.

 

2

----

 

**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

(Unaudited)

 
| ** **                                                                  | ** ** | **For the Three Months Ended** | ** ** | **For the Six Months Ended** | ** ** |
|-----------------------------------------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                                                                  | ** ** | **June 30,**              | ** ** | **June 30,**            | ** ** |
| ** **                                                                  | ** ** | **2005**                       | ** ** | **2004**                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                  | ** ** | **(Dollars in thousands,**     | ** ** |
| ** **                                                                  | ** ** | **except per share data)**     | ** ** |
| Interest income:                                                            | ** ** | ** **                     | ** ** | ** **                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Loans, including fees                                                       |       | $                              | 5,675      |                         | $          | 3,920 |   | $ | 11,118 |   | $ | 7,705 |   |
| Securities                                                                  |       | 377                            |       | 371                          |       | 745 |   | 670 |   |
| Due from banks - interest bearing                                           |       | 18                             |       | 13                           |       | 34 |   | 28 |   |
| Federal funds sold and securities purchased under  agreements to resell     |       | 19                             |       | 12                           |       | 29 |   | 54 |   |
| Total interest income                                                       |       | 6,089                          |       | 4,316                        |       | 11,926 |   | 8,457 |   |
| Interest expense:                                                           |       |                           |       |                         |       |   |   |   |   |
| Deposits:                                                                   |       |                           |       |                         |       |   |   |   |   |
| Interest-bearing demand                                                     |       | 35                             |       | 19                           |       | 67 |   | 36 |   |
| Money market and savings                                                    |       | 234                            |       | 183                          |       | 454 |   | 346 |   |
| Time certificates of deposit:                                               |       |                           |       |                         |       |   |   |   |   |
| $100,000 or more                                                            |       | 259                            |       | 74                           |       | 467 |   | 157 |   |
| Under $100,000                                                              |       | 152                            |       | 105                          |       | 294 |   | 218 |   |
| Total interest expense on deposits                                          |       | 680                            |       | 381                          |       | 1,282 |   | 757 |   |
| Federal funds purchased and securities sold under  agreements to repurchase |       | —                         |       | 2                            |       | — |   | 2 |   |
| Junior subordinated deferrable interest debentures                          |       | 297                            |       | 228                          |       | 577 |   | 454 |   |
| Other borrowings                                                            |       | 39                             |       | 83                           |       | 133 |   | 171 |   |
| Total interest expense                                                      |       | 1,016                          |       | 694                          |       | 1,992 |   | 1,384 |   |
| Net interest income before provision for credit  losses                     |       | 5,073                          |       | 3,622                        |       | 9,934 |   | 7,073 |   |
| Provision for credit losses                                                 |       | —                         |       | —                       |       | 89 |   | — |   |
| Net interest income after provision for credit  losses                      |       | 5,073                          |       | 3,622                        |       | 9,845 |   | 7,073 |   |
| Other operating income:                                                     |       |                           |       |                         |       |   |   |   |   |
| Net gain on sale of securities available-for-sale                           |       | —                         |       | —                       |       | — |   | 19 |   |
| International services                                                      |       | 16                             |       | 7                            |       | 26 |   | 21 |   |
| Investment division                                                         |       | 14                             |       | 13                           |       | 29 |   | 25 |   |
| Deposit-related and other customer services                                 |       | 269                            |       | 382                          |       | 566 |   | 802 |   |
| Total other operating income                                                |       | 299                            |       | 402                          |       | 621 |   | 867 |   |
| Other operating expenses:                                                   |       |                           |       |                         |       |   |   |   |   |
| Salaries and related benefits                                               |       | 1,848                          |       | 1,887                        |       | 3,686 |   | 3,755 |   |
| Net occupancy                                                               |       | 239                            |       | 324                          |       | 485 |   | 615 |   |
| Furniture and equipment                                                     |       | 124                            |       | 162                          |       | 251 |   | 298 |   |
| Printing and communications                                                 |       | 119                            |       | 148                          |       | 264 |   | 281 |   |
| Insurance and regulatory assessments                                        |       | 105                            |       | 103                          |       | 213 |   | 220 |   |
| Client services                                                             |       | 147                            |       | 148                          |       | 319 |   | 280 |   |
| Computer data processing                                                    |       | 218                            |       | 224                          |       | 450 |   | 485 |   |
| Legal services                                                              |       | 308                            |       | 78                           |       | 456 |   | 181 |   |
| Other professional services                                                 |       | 285                            |       | 191                          |       | 539 |   | 373 |   |
| Amortization of core deposit intangible                                     |       | 56                             |       | 56                           |       | 112 |   | 112 |   |
| Retirement of fixed assets and leasehold  improvements                      |       | —                         |       | 43                           |       | — |   | 43 |   |
| Promotion and other expenses                                                |       | 150                            |       | 75                           |       | 310 |   | 219 |   |
| Total other operating expenses                                              |       | 3,599                          |       | 3,439                        |       | 7,085 |   | 6,862 |   |
| Income before income tax provision                                          |       | 1,773                          |       | 585                          |       | 3,381 |   | 1,078 |   |
| Income tax provision                                                        |       | 736                            |       | 240                          |       | 1,403 |   | 442 |   |
| Net income                                                                  |       | $                              | 1,037      |                         | $          | 345 |   | $ | 1,978 |   | $ | 636 |   |
| Earnings per share:                                                         |       |                           |       |                         |       |   |   |   |   |
| Basic                                                                       |       | $                              | 0.33       |                         | $          | 0.12 |   | $ | 0.65 |   | $ | 0.22 |   |
| Diluted                                                                     |       | $                              | 0.22       |                         | $          | 0.08 |   | $ | 0.42 |   | $ | 0.14 |   |

 

See accompanying notes toconsolidated financial statements.

 

3

----

 

**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(Unaudited)

 
| ** **                                                                                   | ** ** | **For the Six Months Ended June 30,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                   | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| ** **                                                                                   | ** ** | **(Dollars in thousands)**                 | ** ** |
| Cash flows from operating activities:                                                        |       |                                       |       |   |   |
| Net income                                                                                   |       | $                                          | 1,978      |   | $ | 636 |   |
| Adjustments to reconcile net income to net cash  provided by (used in) operating activities: |       |                                       |       |   |   |
| Depreciation and amortization                                                                |       | 207                                        |       | 290 |   |
| Provision for credit losses                                                                  |       | 89                                         |       | — |   |
| Gain on sale of securities available for sale                                                |       | —                                     |       | (19 | ) |
| Net amortization of premium on securities available-for-sale                                 |       | 37                                         |       | 109 |   |
| Net amortization of premium on securities held-to-maturity                                   |       | 16                                         |       | 26 |   |
| Net amortization of core deposit intangible                                                  |       | 112                                        |       | 112 |   |
| Net amortization of premium on loans purchased                                               |       | 83                                         |       | 100 |   |
| Decrease in accrued interest receivable and other  assets                                    |       | 331                                        |       | 90 |   |
| Decrease in accrued interest payable and other  liabilities                                  |       | (256                                       | )          | (317 | ) |
| Net cash provided by operating activities                                                    |       | 2,597                                      |       | 1,027 |   |
| Cash flows from investing activities:                                                        |       |                                       |       |   |   |
| Purchase of securities available-for-sale                                                    |       | (8,682                                     | )          | (22,532 | ) |
| Proceeds from sales of securities available-for-sale                                         |       | —                                     |       | 2,019 |   |
| Proceeds from repayments and maturities of  securities available-for-sale                    |       | 2,278                                      |       | 3,067 |   |
| Proceeds from repayments and maturities of  securities held-to-maturity                      |       | 443                                        |       | 546 |   |
| Loan payoffs (originations) and principal  collections, net                                  |       | 5,995                                      |       | (25,380 | ) |
| Net (purchase) of Federal Reserve Stock and other  stocks                                    |       | (87                                        | )          | (874 | ) |
| Purchases of premises and equipment                                                          |       | (255                                       | )          | (316 | ) |
| Net cash provided by (used in) investing activities                                          |       | (308                                       | )          | (43,470 | ) |
| Cash flows from financing activities:                                                        |       |                                       |       |   |   |
| Net increase in demand deposits, money market and  savings accounts                          |       | 23,287                                     |       | 28,540 |   |
| Net increase (decrease) in time certificates of  deposit                                     |       | 13,481                                     |       | (5,242 | ) |
| Net decrease in securities sold under agreements to  repurchase and federal funds purchased  |       | —                                     |       | (399 | ) |
| Net (decrease) increase in other borrowings                                                  |       | (25,900                                    | )          | 8,900 |   |
| Net proceeds from exercise of stock options                                                  |       | 222                                        |       | 78 |   |
| Net cash provided by financing activities                                                    |       | 11,090                                     |       | 31,877 |   |
| Net increase in cash and cash equivalents                                                    |       | 13,379                                     |       | (10,566 | ) |
| Cash and cash equivalents, January 1                                                    |       | 16,915                                     |       | 39,284 |   |
| Cash and cash equivalents, June 30                                                      |       | $                                          | 30,294     |   | $ | 28,718 |   |
|                                                                                         |       |                                       |       |   |   |
| Supplemental disclosures of cash flow information:                                           |       |                                       |       |   |   |
| Cash paid for interest                                                                       |       | $                                          | 1,857      |   | $ | 1,152 |   |
| Cash paid for income taxes                                                                   |       | $                                          | 800        |   | $ | 28 |   |

 

See accompanying notes toconsolidated financial statements.

 

4

----

 

**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 reflect all interim adjustments, which are of a normal recurringnature and which, in management’s opinion, are necessary for the fairpresentation of the Company’s consolidated financial position and results ofoperations and cash flows for such interim periods. The results for the threemonths and six months ended June 30, 2005 are not necessarily indicativeof the results expected for any subsequent period or for the full year ending December 31,2005.  The unaudited consolidatedfinancial statements should be read in conjunction with the auditedconsolidated financial statements included in the Company’s Annual Report on Form 10-KSBfor the year ended December 31, 2004.

 

NOTE 2—EARNINGS PER SHARE

 

Basicearnings per share are computed using the weighted average number of commonshares outstanding during the period. The weighted average number of common shares outstanding used incomputing basic earnings per share and diluted earnings per share was 3,126,701and 4,703,484, respectively, for the three months ended June 30, 2005 and 3,050,237and 4,689,249, respectively, for the six months ended June 30, 2005.   The weighted average number of common sharesoutstanding used in computing basic earnings per share and diluted earnings pershare was 2,906,241 and 4,551,564, respectively, for the three months ended June 30,2004 and 2,858,382 and 4,607,981, respectively, for the six months ended June 30,2004.

 

 

 

5

----

 

Thefollowing table is a reconciliation of income and shares used in thecomputation of basic and diluted earnings per share:

 
| ** **                                       | ** ** | **Earnings**       | ** ** | **Weighted** | ** ** | ** **    | ** ** |
|--------------------------------------------------|------------|--------------------|------------|--------------|------------|---------------|------------|
| ** **                                       | ** ** | **available to**   | ** ** | **Average**  | ** ** | **Per share** | ** ** |
| ** **                                       | ** ** | **shareholders**   | ** ** | **Shares**   | ** ** | **amount**    | ** ** |
| ** **                                       | ** ** | **(in thousands)** | ** ** | ** **   | ** ** | ** **    | ** ** |
|                                             |       |               |       |         |       |          |       |
| *For the three months ended June 30, 2005:* |       |               |       |         |       |          |       |
| Basic EPS                                        |       | $                  | 1,037      |         | 3,126,701  |          | $          | 0.33 |   |
|                                             |       |               |       |         |       |          |       |
| Effect of dilutive securities:                   |       |               |       |         |       |          |       |
| Options                                          |       |               |       | 200,083      |       |          |       |
| Convertible preferred stock                      |       |               |       | 1,376,700    |       |          |       |
| Diluted earnings per share                       |       | $                  | 1,037      |         | 4,703,484  |          | $          | 0.22 |   |
|                                             |       |               |       |         |       |          |       |
| *For the three months ended June 30, 2004:* |       |               |       |         |       |          |       |
| Basic and diluted loss per share                 |       | $                  | 345        |         | 2,906,241  |          | $          | 0.12 |   |
|                                             |       |               |       |         |       |          |       |
| Effect of diultive securities:                   |       |               |       |         |       |          |       |
| Options                                          |       |               |       | 140,001      |       |          |       |
| Convertible preferred stock                      |       |               |       | 1,505,322    |       |          |       |
| Diluted earnings per share                       |       | 345                |       | 4,551,564    |       | $             | 0.08       |   |
|                                             |       |               |       |         |       |          |       |
| *For the six months ended June 30, 2005:*   |       |               |       |         |       |          |       |
| Basic EPS                                        |       | $                  | 1,978      |         | 3,050,237  |          | $          | 0.65 |   |
|                                             |       |               |       |         |       |          |       |
| Effect of dilutive securities:                   |       |               |       |         |       |          |       |
| Options                                          |       |               |       | 198,549      |       |          |       |
| Convertible preferred stock                      |       |               |       | 1,440,463    |       |          |       |
| Diluted earnings per share                       |       | $                  | 1,978      |         | 4,689,249  |          | $          | 0.42 |   |
|                                             |       |               |       |         |       |          |       |
| *For the six months ended June 30, 2004:*   |       |               |       |         |       |          |       |
| Basic EPS                                        |       | $                  | 636        |         | 2,858,382  |          | $          | 0.22 |   |
|                                             |       |               |       |         |       |          |       |
| Effect of dilutive securities:                   |       |               |       |         |       |          |       |
| Options                                          |       |               |       | 245,782      |       |          |       |
| Convertible preferred stock                      |       |               |       | 1,503,817    |       |          |       |
| Diluted earnings per share                       |       | $                  | 636        |         | 4,607,981  |          | $          | 0.14 |   |

 

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.

 

6

----

 

NOTE 4—ALLOWANCE FOR CREDIT LOSSES 

 

Provisions for creditlosses charged to operations reflect management’s judgment of the adequacy ofthe allowance for credit losses and are determined through periodic analysis ofthe loan portfolio.  This analysisincludes a detailed review of the classification and categorization of problemloans; an assessment of the overall quality and collectibility of theportfolio; and consideration of the loan loss experience, trends in problemloans, concentrations of credit risk, as well as current economic conditions(particularly Southern California). Management performs a periodic risk and credit analysis, the results ofwhich are reported to the Board of Directors.

 

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

 

**Analysisof Changes in Allowance for Credit Losses**

 
| ** **                                                            | ** ** | **Three Months ended**     | ** ** | **Six Months ended**       | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                                                            | ** ** | **June 30,**          | ** ** | **June 30,**          | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
| ** **                                                            | ** ** | **2005**                   | ** ** | **2004**                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                            | ** ** | **(Dollars in thousands)** | ** ** | **(Dollars in thousands)** | ** ** |
| ** **                                                            | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance, beginning of period                                          |       | $                          | 4,014      |                       | $          | 3,633 |   | $ | 3,928 |   | $ | 3,635 |   |
| Loans charged off:                                                    |       |                       |       |                       |       |   |   |   |   |
| Commercial - secured and unsecured                                    |       | —                     |       | —                     |       | 6 |   | 31 |   |
| Real estate loans:                                                    |       |                       |       |                       |       |   |   |   |   |
| Secured by commercial real properties                                 |       | —                     |       | —                     |       | — |   | — |   |
| Secured by one to four family residential properties                  |       | —                     |       | —                     |       | — |   | — |   |
| Secured by multifamily residential properties                         |       | —                     |       | —                     |       | — |   | — |   |
| Total real estate loans                                               |       | —                     |       | —                     |       | — |   | — |   |
| Construction and land development                                     |       | —                     |       | —                     |       | — |   | — |   |
| Consumer installment, home equity and unsecured  loans to individuals |       | —                     |       | —                     |       | — |   | 4 |   |
| Total loans charged-off                                               |       | —                     |       | —                     |       | 6 |   | 35 |   |
|                                                                  |       |                       |       |                       |       |   |   |   |   |
| Recoveries of loans previously charged off:                           |       |                       |       |                       |       |   |   |   |   |
| Commercial - secured and unsecured                                    |       | 131                        |       | 57                         |       | 133 |   | 68 |   |
| Real estate loans:                                                    |       |                       |       |                       |       |   |   |   |   |
| Secured by commercial real properties                                 |       | —                     |       | —                     |       | — |   | — |   |
| Secured by one to four family residential properties                  |       | —                     |       | —                     |       | — |   | — |   |
| Secured by multifamily residential properties                         |       | —                     |       | —                     |       | — |   | — |   |
| Total real estate loans                                               |       | —                     |       | —                     |       | — |   | — |   |
| Construction and land development                                     |       | —                     |       | —                     |       | — |   | 6 |   |
| Consumer installment, home equity and unsecured  loans to individuals |       | 1                          |       | 1                          |       | 2 |   | 17 |   |
| Total recoveries of loans previously charged off                      |       | 132                        |       | 58                         |       | 135 |   | 91 |   |
| Net charge-offs                                                       |       | (132                       | )          | (58                        | )          | (129 | ) | (56 | ) |
| Provision for credit losses                                           |       | —                     |       | —                     |       | 89 |   | — |   |
| Balance, end of period                                                |       | $                          | 4,146      |                       | $          | 3,691 |   | $ | 4,146 |   | $ | 3,691 |   |

 

Creditquality is affected by many factors beyond the control of the Company,including local and national economies, and facts may exist which are not knownto the Company that adversely affect the likelihood of repayment of variousloans in the loan portfolio and realization of collateral upon a default.Accordingly, no assurance can be given that the Company will not sustain loanlosses materially in excess of the allowance for credit losses. In addition,the Office of the Comptroller of the

 

7

----

 

Currency, (“OCC”), as anintegral part of its examination process, periodically reviews the allowancefor credit losses and could require additional provisions for credit losses.

 

NOTE 5—GOODWILL AND CORE DEPOSIT INTANGIBLES

 

As of June 30,2005 and December 31, 2004, the Company had goodwill of $3.2 million, andnet 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 June 30, 2005 and December 31, 2004,and accumulated amortization was $782,000 and $670,000, respectively, at suchdates.  The core deposit intangibles areestimated to have a life of 10 years and 4 months. Amortization for intangiblesfor 2005 and each of the next four years is estimated to be $223,000 peryear.  In accordance with SFAS No. 142goodwill is not amortized.  The Companyhas no other recorded indefinite-lived intangible assets.  Goodwill and other intangible assets arereviewed and assessed annually for impairment or more frequently if conditionssuggest impairment may exist.

 

NOTE 6—INCOME TAXES

 

Incometax provisions of $736,000 and $240,000 were recorded for the three monthsended June 30, 2005 and 2004, respectively.  Income tax provisions of $1,403,000 and$442,000 were recorded for the six months ended June 30, 2005 and 2004,respectively.

 

At June 30, 2005,the Company had: (i) federal net operating loss carry forwards (“NOLS”) ofapproximately $9.7 million, which begin to expire in the year 2009; and (ii) federalalternative minimum tax “AMT” credits of $364,000.  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

 

Theestimated per share weighted average fair value of options granted in the threemonths ended June 30, 2005 and 2004 was $9.72 and $6.85,respectively.  The estimated per shareweighted average fair value of options granted in the six months ended June 30,2005 and 2004 was $9.59 and $6.95, respectively.  The Company applies Accounting PrinciplesBoard Opinion No. 25 and related interpretations in accounting for itsstock incentive plans.  SFAS No. 123,Accounting for Stock-Based

 

8

----

 

Compensation, encourages,but does not require, companies to record compensation cost for stock-basedemployee compensation plans at fair value. Accordingly and in accordance with the principle contained in APBO 25,no compensation cost has been recognized for the options.  Had compensation cost for the options grantedbeen determined based on the fair value at the grant dates for awardsconsistent with the method of SFAS No. 123, the Company’s net income forthe three months and six months ended June 30, 2005 and 2004 would havedecreased to the pro forma amounts indicated below:

 
| ** **                                                                                                                            | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                                            | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                                                            | ** ** | **(Dollars in thousands,**           | ** ** | **(Dollars in thousands,**         | ** ** |
| ** **                                                                                                                            | ** ** | **except per share data)**           | ** ** | **except per share data)**         | ** ** |
| Net Income:                                                                                                                           |       |                                 |       |                               |       |   |   |   |   |
| As reported                                                                                                                           |       | $                                    | 1,037      |                               | $          | 345 |   | $ | 1,978 |   | $ | 636 |   |
|                                                                                                                                  |       |                                 |       |                               |       |   |   |   |   |
| Total stock-based employee compensation expense  determined under fair value based method for all awards, net of related tax  effects |       | 41                                   |       | 35                                 |       | 78 |   | 57 |   |
| Pro forma                                                                                                                             |       | $                                    | 996        |                               | $          | 310 |   | $ | 1,900 |   | $ | 579 |   |
|                                                                                                                                  |       |                                 |       |                               |       |   |   |   |   |
| Income Per Share as reported:                                                                                                         |       |                                 |       |                               |       |   |   |   |   |
| Basic                                                                                                                                 |       | $                                    | 0.33       |                               | $          | 0.12 |   | $ | 0.65 |   | $ | 0.22 |   |
| Diluted                                                                                                                               |       | 0.22                                 |       | 0.08                               |       | 0.42 |   | 0.14 |   |
| Income Per Share Pro forma:                                                                                                           |       |                                 |       |                               |       |   |   |   |   |
| Basic                                                                                                                                 |       | $                                    | 0.32       |                               | $          | 0.11 |   | $ | 0.62 |   | $ | 0.20 |   |
| Diluted                                                                                                                               |       | 0.21                                 |       | 0.07                               |       | 0.41 |   | 0.13 |   |

 

Thefair values of options granted during the three months ended June 30, 2005and 2004 were estimated on the date of grant using the Black-Scholesoption-pricing model with the following weighted-average assumptions used:2005— no dividend yield, expected volatility of 43%, risk-free interest rate of3.94%, and an expected life of 10 years; 2004— no dividend yield, expectedvolatility of 57%, risk-free interest rate of 4.60%, and an expected life of 10years.

 

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.

 

9

----

 

NOTE 8—COMPREHENSIVE INCOME (LOSS)

 

Comprehensiveincome (loss) is the change in equity during a period from transactions andother events and circumstances from nonowner sources.  The accumulated balance of othercomprehensive income (loss) is required to be displayed separately fromretained earnings in the consolidated balance sheet.  Total comprehensive income (loss) was asfollows:

 
|                                                                                |   | **Three Months ended June 30,** |       | **Six Months ended June 30,** |   |
|-------------------------------------------------------------------------------------|--------|--------------------------------------|------------|------------------------------------|--------|
|                                                                                |   | **2005**                             | ** ** | **2004**                           |   | **2005** | ** ** | **2004** |   |
|                                                                                |   | **(Dollars in thousands)**           |       | **(Dollars in thousands)**         |   |
|                                                                                |   |                                 |       |                               |   |   |   |   |   |
| Net income (loss)                                                                   |   | $                                    | 1,037      |                               | $      | 345 |   | $ | 1,978 |   | $ | 636 |   |
|                                                                                |   |                                 |       |                               |   |   |   |   |   |
| Other comprehensive income (loss) before tax, and  unrealized losses on securities: |   |                                 |       |                               |   |   |   |   |   |
| Unrealized gain (loss) on interest rate swaps used  in cash flow hedges             |   | 712                                  |       | —                             |   | (370 | ) | — |   |
| Unrealized gain (loss) on interest rate floors used  in cash flow hedges            |   | (26                                  | )          | —                             |   | (26 | ) | — |   |
| Unrealized gain (loss) on securities available for  sale                            |   | 260                                  |       | (377                               | )      | (34 | ) | (346 | ) |
| Other comprehensive income (loss), before tax                                       |   | 946                                  |       | (377                               | )      | (430 | ) | (346 | ) |
|                                                                                |   |                                 |       |                               |   |   |   |   |   |
| Income tax benefit (expense) related to items of  other comprehensive income        |   | (388                                 | )          | 155                                |   | 179 |   | 142 |   |
| Other comprehensive income (loss)                                                   |   | 558                                  |       | (222                               | )      | (251 | ) | (204 | ) |
| Total comprehensive income                                                          |   | $                                    | 1,595      |                               | $      | 123 |   | $ | 1,727 |   | $ | 432 |   |

 

NOTE 9—DERIVATIVE FINANCIAL INSTRUMENTS

 

In January 2003,National Mercantile entered into an interest rate swap agreement pursuant towhich it exchanged a fixed rate payment obligation of 10.25% on a notionalprincipal amount of $15.0 million for a floating rate interest based on thesix-month London InterBank Offered Rate plus 458 basis points for a 29-yearperiod ending July 25, 2031.  Theinterest rate swap agreement results in National Mercantile paying or receivingthe difference between the fixed and floating rates at specified intervalscalculated on the notional amounts.  Thedifferential paid or received on the interest rate swap is recognized as anadjustment to interest expense.  At June 30,2005, National Mercantile was paying an interest rate of 7.50% under the termsof the swap.  The counter party to theswap has the option to call the swap under a declining premium schedule beginningJuly

 

10

----

 

2006.  By use of this interest rate swap, theCompany is hedging against a decline in rates in its portfolio of adjustablerate loans receivable.

 

TheCompany does not utilize derivatives for speculative purposes.  The interest rate swap reduces the cost ofthe 10.25% fixed-rate Junior Subordinated Debentures in a low interest rateenvironment.  This swap transaction isdesignated as hedging the exposure to variability in expected future cash flowsthat is attributable to a changes in interest rates on the Companiesadjustable-rate loans (a fair value hedge). Accordingly, the ineffective portion of the change in the fair value ofthe swap transaction is recorded each period in current operations.  The terms of the swap are symmetrical withthe terms of the Junior Subordinated Debentures, including the payment deferralterms, and considered highly effective in offsetting changes in fair value ofthe Junior Subordinated Debentures.  A $507,000increase in the fair value of the swap was recorded in income for thethree-month period ended June 30, 2005 with an offsetting charge toearnings to reflect a similar decrease in the fair value of the JuniorSubordinated Debentures.   Noineffectiveness was recorded to current earnings related to the interest rateswap.

 

Theterms of the swap require National Mercantile to provide collateral to supportits contract obligations and varies based upon the swap contract value.  At June 30, 2005, $1.0 million of theCompany’s securities were pledged as collateral.

 

In July 2004,the Banks entered into interest rate swap agreements in which they exchanged anadjustable rate interest based on the prime rate lending index for a fixed ratepayment of 6.925% on an aggregate notional principal amount beginning at $50.0million for a 4-year period, declining to $30.0 million for the fifth year and$10.0 million for the sixth year with a final maturity of June 30,2010.  The interest rate swap agreementresults in the Banks paying or receiving the difference between the fixed andfloating rates at monthly intervals calculated on the notional amounts.  The differential paid or received on theinterest rate swap has been recognized as an adjustment to interestincome.  At June 30, 2005, the Bankswere paying an interest rate of 7.50% under the terms of the swap.

 

Theseinterest rate swaps reduce the current asset sensitivity of the Company’sbalance sheet moderating the potential negative impact on earnings in the eventof declining interest rates.  The Companydoes not utilize derivatives for speculative purposes.  These swap transactions have been designatedas cash flow hedges.  Accordingly, thechange in fair value of the swaps is recorded each period as othercomprehensive income and any ineffective portion of the change in the fairvalue is recorded in current operations. The Company has a large portion of its loan portfolio that adjusts tochanges in the prime rate lending index and therefore the swaps are currentlyconsidered highly effective in offsetting changes in the cash flows of the loanportfolio.

 

11

----

 

On May 5,2005, National Mercantile purchased several interest rate floors based upon theprime rate lending index as follows: (i) $150.0 million with a strike rateof 5.50% that expires May 6, 2006; (ii) $25.0 million with a strikerate of 5.75% that expires May 6, 2008; (iii) $25.0 million with astrike rate of 5.50% that expires May 6, 2010; and (iv) $25.0 millionwith a strike rate of 5.25% that expires May 6, 2012.   In the event, and for the number of days,that the actual prime rate is less than the strike rate, the counter party tothe interest rate floors will pay the Company the difference between the actualprime rate and the strike rate calculated on the notional amounts.  The Company has passed the effect of theinterest rate floors to the Banks by entering into reciprocal interest ratefloors in the aggregate notional amount.

 

Theseinterest rate floors reduce the current asset sensitivity of the Company’sbalance sheet moderating the potential negative impact on earnings in the eventof declining interest rates.  The Companydoes not utilize derivatives for speculative purposes.  The three $25.0 million floors have beendesignated as cash flow hedges. Accordingly, the change in fair value of the floors is recorded eachperiod as other comprehensive income and any ineffective portion of the changein the fair value is recorded in current operations.  The Company has a large portion of its loanportfolio that adjusts to changes in the prime rate lending index and,therefore, the floors are currently considered highly effective in offsettingchanges in the cash flows of the loan portfolio.  At June 30, 2005 losses of $26,000 and $8,000were recorded in other comprehensive income and current operations,respectively, for these interest rate floors.   The $150.0 million interest rate floor hasnot been designated as a hedge and accordingly, the change in fair value isrecorded in current operations.   For thequarter ended June 30, 2005 an $8,000 loss was recorded in currentoperations for this floor.  The premiumspaid for the interest rate floors are amortized over the life of the floors.

 

NOTE 10— CONVERSION OF PREFERRED STOCK

 

Pursuantto the election of 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.  During the six months ended June 30, 2005, 666,273shares of Series A Preferred were converted into 1,332,546 shares ofcommon stock.

 

NOTE 11—RECLASSIFICATIONS

 

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

 

12

----

 

***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**

 

The Company recorded netincome of $1,037,000, or $0.33 basic earnings per share and $0.22 dilutedearnings per share, for the three months ended June 30, 2005 compared tonet income of $345,000, or $0.12 basic earnings per share and $0.08 dilutedearnings per share, for the same period of 2004.   The increase in net income for the secondquarter of 2005 was primarily due to a $1.5 million increase in net interestincome before the provision for credit losses resulting from increases in theprime rate lending index, interest rate swaps, a greater volume of interestearning assets, particularly higher-yielding loans receivable and securitiesavailable-for-sale, and a favorable change in earning asset and fundingliability composition.

 

The Company recorded netincome of $1,978,000, or $0.65 basic earnings per share and $0.42 dilutedearnings per share, for the six months ended June 30, 2005 compared to netincome of $636,000, or $0.22 basic earnings per share and $0.14 dilutedearnings per share, for the same period of 2004.   The increase in net income for the 2005period was primarily due to a $2.8 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.

 

Return on average assetsduring the second quarter and first half of 2005 was 1.09% and 1.03%,respectively, compared to 0.37% and 0.35% during the second quarter and firsthalf of 2004, respectively. Return on average equity during the second quarterand first half of 2005 was 11.64% and 11.23%, respectively, compared to 4.28%and 3.95% during the second quarter and first half of 2004, respectively.

 

NET INTEREST INCOME

 

Netinterest income before the provision for credit losses increased $1.5 millionfor the three months ended June 30, 2005 compared to the same quarter of2004 due to a $1.8 million increase in total interest income partially offsetby a $322,000

 

13

----

 

increase in interest expense.  Loan interest income increased $1.8 milliondue to a $29.3 million greater average volume of loans receivable and a 176basis point increase in yield, resulting primarily from increases in the primerate lending index and interest rate swaps. On July 1, 2004, the Banks entered into interest rate swapagreements in which they exchanged an adjustable rate interest based on theprime rate lending index for a fixed rate payment of 6.925% on an aggregatenotional principal amount of $50.0 million (see Note 9—Derivative FinancialInstruments of the Notes to Consolidated Financial Statements for details ofthe swap terms).  The interest rate swapscontributed $128,000 to interest income or 17 basis points to the increase inloan yield.  During the second half of2004 and first half of 2005, the Federal Reserve Bank increased the federalfunds rate on nine occasions totaling 225 basis points, after a prolongedperiod of accommodative monetary policy, in response to signs of a strongerexpansion of the economy.  Approximately 75%of our $307.5 million loans receivable have adjustable interest rates;accordingly, rising interest rates positively affects interest income partiallyoffset by greater payments on our $50 million of interest rate swaps.

 

Interestincome from securities available-for-sale remained the same during the secondquarter 2005 compared to the second quarter 2004 due to a 46 basis pointincrease in yield even with a $6.3 million decrease in average volume.  The increase in the yield on securitiesavailable-for-sale was due to higher yields on recently purchasedsecurities.  The decrease in securitieswas due to maturities and principal paydowns of existing securities.

 

Overall,interest-earning assets were $17.9 million greater during the second quarter2005 than second quarter 2004 and the higher yields and favorable change incomposition to higher-yielding assets resulted in a 175 basis point increase inweighted average yield on interest-earning assets.

 

Interestexpense increased $322,000 for the three months ended June 30, 2005compared to the same period in 2004, due primarily to a 59 basis point increasein cost of funds.  The averageinterest-bearing liabilities remained unchanged at $219.6 million for bothquarters.   Average interest-bearingdeposits were $5.2 million greater than the second quarter 2004.  Interest expense on deposits increased $299,000due to a 58 basis point increase in weighted average cost and a $5.2 millionincrease in average interest-bearing deposits. Relatively low costinginterest-bearing demand deposits and money market and savings deposits averaged$1.6 million and $15.5 million less, respectively, in the 2005 period comparedto the 2004 period.  The decrease intransactional deposits is due to depositors redeploying their funds to theCompany’s higher yielding certificates of deposit and alternative investmentsoutside the Banks.  Time certificates ofdeposit averaged $22.3 million more during the second quarter 2005 than thesame period in 2004.  The cost of timecertificates of deposit increased 84 basis points due to higher rates on newcertificates and repricing of matured certificates during the higher interestrate environment.  Rising market

 

14

----

 

rates of interest duringthe latter half of 2004 and first half of 2005 resulted in the cost ofinterest-bearing demand deposits and money market and savings deposits toincrease a moderate 21 basis points and 31 basis points, respectively, comparedto the second quarter of 2004.  TheCompany elected to only moderately increase transaction deposit rates and to fundearning asset growth during 2005 with time certificates of deposit andrelatively inexpensive overnight other borrowings.  Other borrowings during the second quarter2005 averaged $5.4 million, or $5.1 million less than the same period in2004.  The cost of other borrowings was 2.89%and 3.17% for the second quarters of 2005 and 2004, respectively, representinga decline of 28 basis points in 2005 due to a greater volume of short-termadvances and the maturity of higher-costing longer term advances.  In a sustained rising interest rateenvironment, increases in deposit interest rates will be required to preventnet deposit withdrawals. Noninterest-bearing demand deposits increased $5.7 million in averagevolume in the second quarter 2005 compared to the same period in 2004.

 

TheCompany altered its liquidity strategy during 2004, maintaining a significantlylower level of short-term assets, primarily federal funds sold, and relying onovernight other borrowings against pledged loans and securities to fund loangrowth and deposit outflows.  Liquiditywas supplemented with customer and brokered time certificates of deposit.  This type of funding is typically highercosting and exhibits higher interest rate sensitivity.  The relatively high cost of new time certificatesof deposit, however, impacts a relatively small portion of the Company’s fundingsources.

 

Thenet yield on interest earning assets increased 1.43 basis points from 4.38%during the second quarter in 2004 to 5.81% in the second quarter in 2005, whilethe net interest spread increased 116 basis points from 3.95% during the secondquarter in 2004 to 5.11% in the second quarter in 2005.

 

Netinterest income before the provision for credit losses increased $2.8 millionfor the six months ended June 30, 2005 compared to the same period of 2004due to a $3.5 million increase in total interest income.  Loan interest income increased $3.4 milliondue to $39.2 million greater average volume of loans receivable and a 152 basispoint increase in yield, resulting primarily from increases in the prime ratelending index and interest rate swaps. The interest rate swaps contributed 21 basis points to the increase inloan yield.

 

Interestincome from securities available-for-sale increased $90,000 during the first halfof 2005 compared to the first half of 2004 due to a 42 basis point increase inyield with average volume increasing only slightly.  The increase in the yield on securitiesavailable-for-sale was due to higher yields on the recently purchasedsecurities.

 

15

----

 

Overall,interest-earning assets were $27.5 million greater during the first half of2005 than first half of 2004 and the higher yields and favorable change incomposition to higher-yielding assets resulted in a 159 basis point increase inweighted average yield on interest-earning assets.

 

Interestexpense increased $608,000 for the six months ended June 30, 2005 comparedto the same period in 2004, due to a $14.9 million increase in averageinterest-bearing liabilities and a 46 basis point increase in cost offunds.   Average interest-bearingdeposits were $13.8 million greater than the first half of 2004.  Interest expense on deposits increased $525,000due to a 48 basis point increase in weighted average cost and a $13.8 millionincrease in average interest-bearing deposits. Relatively low costing moneymarket and savings deposits averaged $6.5 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 $20.0 million more during the first half of 2005 than the same periodin 2004.  The cost of time certificatesof deposit increased 68 basis points due to higher rates on new certificatesand repricing of matured certificates during the higher interest rateenvironment.  Rising market rates ofinterest during the latter half of 2004 and first half of 2005 resulted in thecost of interest-bearing demand deposits and money market and savings depositsincreasing a moderate 20 basis points and 26 basis points, respectively,compared to the first half of 2004.   Other borrowings during the first half of 2005 averaged $10.2 million,or $1.2 million greater than the same period in 2004.  The cost of other borrowings was 2.62% and3.82% for the first half of 2005 and 2004, respectively, representing a declineof 120 basis points in 2005 due to a greater volume of short-term advances andthe maturity of higher-costing longer term advances.  Noninterest-bearing demand deposits wererelatively stable, with an increase of $2.0 million in average volume in thefirst half of 2005 compared to 2004.

 

Thenet yield on interest earning assets increased 131 basis points from 4.36%during the first half of 2004 to 5.67% in the first half of 2005, while the netinterest spread increased 113 basis points from 3.91% during the first half of2004 to 5.04% in the first half in 2005.

 

Thefollowing table presents the components of net interest income for the threemonths ended June 30, 2005 and 2004.

 

16

----

 

**Average Balance Sheet and**

**Analysis of Net Interest Income**

 
| ** **                                                                                     | ** ** | **Three Months ended**     | ** ** |
|------------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                     | ** ** | **June 30, 2005**     | ** ** | **June 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                        |       | $                          | 2,526      |   | 19 |   | 3.02 | % | $ | 4,623 |   | 12 |   | 1.04 | % |
| Due from banks-interest-bearing                                                                |       | 2,032                      |       | 18 |   | 3.55 | % | 4,091 |   | 13 |   | 1.28 | % |
| Securities available-for-sale                                                                  |       | 40,235                     |       | 346 |   | 3.44 | % | 46,495 |   | 346 |   | 2.98 | % |
| Securities held-to-maturity                                                                    |       | 3,194                      |       | 31 |   | 3.88 | % | 4,245 |   | 25 |   | 2.31 | % |
| Loans receivable (1) (2)                                                                  |       | 302,382                    |       | 5,675 |   | 7.53 | % | 273,042 |   | 3,920 |   | 5.77 | % |
| Total interest earning assets                                                                  |       | 350,369                    |       | 6,089 |   | 6.97 | % | 332,496 |   | 4,316 |   | 5.22 | % |
|                                                                                           |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest earning assets:                                                                    |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks - demand                                                               |       | 16,352                     |       |   |   |   |   | 23,194 |   |   |   |   |   |
| Other assets                                                                                   |       | 20,881                     |       |   |   |   |   | 21,796 |   |   |   |   |   |
| Allowance for credit losses and net unrealized gain  on sales of securities available-for-sale |       | (4,358                     | )          |   |   |   |   | (3,695 | ) |   |   |   |   |
| Total assets                                                                                   |       | $                          | 383,244    |   |   |   |   |   | $ | 373,791 |   |   |   |   |   |
|                                                                                           |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Liabilities and shareholders’ equity:                                                     |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing deposits:                                                                     |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Demand                                                                                         |       | $                          | 30,865     |   | 35 |   | 0.45 | % | $ | 32,426 |   | 19 |   | 0.24 | % |
| Money market and savings                                                                       |       | 97,512                     |       | 234 |   | 0.96 | % | 113,038 |   | 183 |   | 0.65 | % |
| Time certificates of deposit:                                                                  |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| $100,000 or more                                                                               |       | 44,198                     |       | 259 |   | 2.35 | % | 21,675 |   | 74 |   | 1.37 | % |
| Under $100,000                                                                                 |       | 26,175                     |       | 152 |   | 2.33 | % | 26,381 |   | 105 |   | 1.60 | % |
| Total time certificates of deposit                                                             |       | 70,373                     |       | 411 |   | 2.34 | % | 48,056 |   | 179 |   | 1.50 | % |
| Total interest-bearing deposits                                                                |       | 198,750                    |       | 680 |   | 1.37 | % | 193,520 |   | 381 |   | 0.79 | % |
| Other borrowings                                                                               |       | 5,404                      |       | 39 |   | 2.89 | % | 10,524 |   | 83 |   | 3.17 | % |
| Junior subordinated debentures                                                                 |       | 15,464                     |       | 297 |   | 7.70 | % | 15,464 |   | 228 |   | 5.93 | % |
| Federal funds purchased and securities** **sold under agreements to repurchase            |       | —                     |       | — |   | 0.00 | % | 132 |   | 2 |   | 6.09 | % |
| Total interest-bearing liabilities                                                             |       | 219,618                    |       | 1,016 |   | 1.86 | % | 219,640 |   | 694 |   | 1.27 | % |
|                                                                                           |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing liabilities:                                                               |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing demand deposits                                                            |       | 126,399                    |       |   |   |   |   | 120,734 |   |   |   |   |   |
| Other liabilities                                                                              |       | 1,497                      |       |   |   |   |   | 1,080 |   |   |   |   |   |
| Shareholders’ equity                                                                      |       | 35,730                     |       |   |   |   |   | 32,337 |   |   |   |   |   |
| Total liabilities and shareholders’ equity                                                |       | $                          | 383,244    |   |   |   |   |   | $ | 373,791 |   |   |   |   |   |
|                                                                                           |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income (spread)                                                                   |       |                       |       | $ | 5,073 |   | 5.11 | % |   |   | $ | 3,622 |   | 3.95 | % |
|                                                                                           |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Net yield on earning assets (2)                                                                |       |                       |       |   |   | 5.81 | % |   |   |   |   | 4.38 | % |
|                                                                                                |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)     The average balance ofnonperforming loans has been included in loans receivable.

(2)     Yields and amounts earned onloans receivable include loan fees of $437,000 and $275,000 for the threemonths ended June 30, 2005 and 2004, respectively.

 

17

----

 

Thefollowing table presents the components of net interest income for the sixmonths ended June 30, 2005 and 2004.

 

**Average Balance Sheet and**

**Analysis of Net Interest Income**

 
| ** **                                                                                     | ** ** | **Six Months ended**       | ** ** |
|------------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                     | ** ** | **June 30, 2005**     | ** ** | **June 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                        |       | $                          | 2,098      |   | 29 |   | 2.79 | % | $ | 11,029 |   | 54 |   | 0.98 | % |
| Due from banks-interest-bearing                                                                |       | 2,378                      |       | 34 |   | 2.88 | % | 4,394 |   | 28 |   | 1.28 | % |
| Securities available-for-sale                                                                  |       | 40,073                     |       | 680 |   | 3.39 | % | 39,707 |   | 590 |   | 2.97 | % |
| Securities held-to-maturity                                                                    |       | 3,304                      |       | 65 |   | 3.93 | % | 4,377 |   | 80 |   | 3.66 | % |
| Loans receivable (1) (2)                                                                  |       | 305,556                    |       | 11,118 |   | 7.34 | % | 266,353 |   | 7,705 |   | 5.82 | % |
| Total interest earning assets                                                                  |       | 353,409                    |       | 11,926 |   | 6.81 | % | 325,860 |   | 8,457 |   | 5.22 | % |
|                                                                                           |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest earning assets:                                                                    |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks - demand                                                               |       | 17,736                     |       |   |   |   |   | 23,078 |   |   |   |   |   |
| Other assets                                                                                   |       | 20,726                     |       |   |   |   |   | 21,646 |   |   |   |   |   |
| Allowance for credit losses and net unrealized gain  on sales of securities available-for-sale |       | (4,213                     | )          |   |   |   |   | (3,611 | ) |   |   |   |   |
| Total assets                                                                                   |       | $                          | 387,658    |   |   |   |   |   | $ | 366,973 |   |   |   |   |   |
|                                                                                           |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Liabilities and shareholders’ equity:                                                     |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing deposits:                                                                     |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Demand                                                                                         |       | $                          | 31,448     |   | 67 |   | 0.43 | % | $ | 31,176 |   | 36 |   | 0.23 | % |
| Money market and savings                                                                       |       | 100,307                    |       | 454 |   | 0.91 | % | 106,794 |   | 346 |   | 0.65 | % |
| Time certificates of deposit:                                                                  |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| $100,000 or more                                                                               |       | 42,352                     |       | 467 |   | 2.22 | % | 22,908 |   | 157 |   | 1.38 | % |
| Under $100,000                                                                                 |       | 26,973                     |       | 294 |   | 2.20 | % | 26,370 |   | 218 |   | 1.66 | % |
| Total time certificates of deposit                                                             |       | 69,325                     |       | 761 |   | 2.21 | % | 49,278 |   | 375 |   | 1.53 | % |
| Total interest-bearing deposits                                                                |       | 201,080                    |       | 1,282 |   | 1.29 | % | 187,248 |   | 757 |   | 0.81 | % |
| Other borrowings                                                                               |       | 10,244                     |       | 133 |   | 2.62 | % | 9,012 |   | 171 |   | 3.82 | % |
| Junior subordinated debentures                                                                 |       | 15,464                     |       | 577 |   | 7.52 | % | 15,464 |   | 454 |   | 5.90 | % |
| Federal funds purchased and securities sold under  agreements to repurchase                    |       | —                     |       | — |   | 0.00 | % | 181 |   | 2 |   | 2.22 | % |
| Total interest-bearing liabilities                                                             |       | 226,788                    |       | 1,992 |   | 1.77 | % | 211,905 |   | 1,384 |   | 1.31 | % |
|                                                                                           |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing liabilities:                                                               |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing demand deposits                                                            |       | 123,917                    |       |   |   |   |   | 121,965 |   |   |   |   |   |
| Other liabilities                                                                              |       | 1,423                      |       |   |   |   |   | 848 |   |   |   |   |   |
| Shareholders’ equity                                                                      |       | 35,530                     |       |   |   |   |   | 32,255 |   |   |   |   |   |
| Total liabilities and shareholders’ equity                                                |       | $                          | 387,658    |   |   |   |   |   | $ | 366,973 |   |   |   |   |   |
|                                                                                           |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income (spread)                                                                   |       |                       |       | $ | 9,934 |   | 5.04 | % |   |   | $ | 7,073 |   | 3.91 | % |
|                                                                                           |       |                       |       |   |   |   |   |   |   |   |   |   |   |
| Net yield on earning assets (2)                                                                |       |                       |       |   |   | 5.67 | % |   |   |   |   | 4.36 | % |
|                                                                                                |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)     The average balance ofnonperforming loans has been included in loans receivable.

(2)     Yields and amounts earned onloans receivable include loan fees of $860,000 and $568,000 for the six monthsended June 30, 2005 and 2004, respectively.

 

18

----

 

The following table setsforth, for the periods indicated, the changes in interest earned and interestpaid resulting from changes in volume and changes in rates.  Average balances in all categories in eachreported period were used in the volume computations.  Average yields and rates in each reportedperiod were used in rate computations.

 

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

**Average Volume andAverage Rate (1)**

 
| ** **                                                                  | ** ** | **Six Months ended June 30,** | ** ** |
|-----------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                  | ** ** | **2005 vs 2004**                   | ** ** |
| ** **                                                                  | ** ** | ** **                         | ** ** | ** ** | ** ** | **Net** | ** ** |
| ** **                                                                  | ** ** | **Increase (decrease) due to:**    | ** ** | **Increase** | ** ** |
| ** **                                                                  | ** ** | **Volume**                         | ** ** | **Rate** | ** ** | **(Decrease)** | ** ** |
|                                                                        |       |                               |       |   |   |   |   |
| Interest Income:                                                            |       |                               |       |   |   |   |   |
| Federal funds sold and securities purchased under  agreement to resell      |       | $                                  | (44        | ) | $ | 19 |   | $ | (25 | ) |
| Interest-bearing deposits with other financial  institutions                |       | (13                                | )          | 19 |   | 6 |   |
| Securities available-for-sale                                               |       | 6                                  |       | 84 |   | 90 |   |
| Securities held-to-maturity                                                 |       | (20                                | )          | 5 |   | (15 | ) |
| Loans receivable (2)                                                        |       | 1,124                              |       | 2,289 |   | 3,413 |   |
| Total interest-earning assets                                               |       | 1,053                              |       | 2,416 |   | 3,469 |   |
|                                                                        |       |                               |       |   |   |   |   |
| Interest Expense:                                                           |       |                               |       |   |   |   |   |
| Interest-bearing deposits:                                                  |       |                               |       |   |   |   |   |
| Demand                                                                      |       | $                                  | 0          |   | $ | 31 |   | $ | 31 |   |
| Money market and savings                                                    |       | (22                                | )          | 130 |   | 108 |   |
| Time certificates of deposit:                                               |       |                               |       |   |   |   |   |
| $100,000 or more                                                            |       | 133                                |       | 177 |   | 310 |   |
| Under $100,000                                                              |       | 5                                  |       | 71 |   | 76 |   |
| Total time certificates of deposit                                          |       | 138                                |       | 248 |   | 386 |   |
| Total interest-bearing deposits                                             |       | 116                                |       | 409 |   | 525 |   |
| Other borrowings                                                            |       | 23                                 |       | (61 | ) | (38 | ) |
| Junior subordinated debentures                                              |       | —                             |       | 123 |   | 123 |   |
| Federal funds purchased and securities sold under  agreements to repurchase |       | (2                                 | )          | — |   | (2 | ) |
| Total interest-bearing liabilities                                          |       | 137                                |       | 471 |   | 608 |   |
|                                                                        |       |                               |       |   |   |   |   |
| Net interest income                                                         |       | $                                  | 916        |   | $ | 1,945 |   | $ | 2,861 |   |

 

----

(1)          The change in interestincome or interest expense that is attributable to both changes in averagebalance and average rate has been allocated to the changes due to (i) averagebalance and (ii) average rate in proportion to the relationship of theabsolute amounts of changes in each.

(2)          Table does not includeinterest income that would have been earned on nonaccrual loans.

 

19

----

 

PROVISIONFOR CREDIT LOSSES

 

The Company recorded no provision forcredit losses for the second quarter 2005 and $89,000 provision for the sixmonths ended June 30, 2005 compared to no provision for the three months andsix months ended June 30, 2004.  Noprovision for credit losses was made in the second quarter due to a decline inloans receivable and recoveries of loans previously charged off.  See Note 4 of Notes to Consolidated FinancialStatements.

 

OTHEROPERATING INCOME

 

Other operating income decreased to$103,000 during the second quarter of 2005 from $402,000 during the secondquarter of 2004 primarily due to an $113,000 decrease in deposit-related andother customer services income resulting from changes in deposit feestructures.

 

Other operating income decreased to$621,000 during the six months ended June 30, 2005 from $867,000 during the sixmonths ended June 30, 2004 primarily due to a $236,000 decrease indeposit-related and other customer services income resulting from changes indeposit fee structures.

 

OTHER OPERATING EXPENSES

 

Other operating expenses increased to $3.6 million for thethree months ended June 30, 2005 compared to $3.4 million for the same periodof 2004. Variances within operating expenses were: (i) salaries andrelated benefits expense decreased $39,000 or 2.1% due to a reduction instaffing levels during the second half of 2004 related to the consolidation ofclient services partially offset by the addition of business development staffand increased commission expense; (ii) net occupancy expense decreased $85,000or 26.2% due to a reduction in rent from the relocation of the Company’sheadquarters office and banking office in Century City; (iii) legal servicesexpense increased $230,000 or 294.9% primarily due to activity on thesettlement of a dispute over collateral securing a borrower’s loan that has nowbeen resolved; and, (iv) other professional services expense increased $94,000or 49.2% due to a productivity consultant engagement and increased costs foraudit services.

 

Otheroperating expenses increased to $7.1 million for the six months ended June 30,2005 compared to $6.9 million for the same period of 2004. Variances withinoperating expenses were: (i) salaries and related benefits expense decreased$69,000 or 1.8% due to a reduction in staffing levels during 2004 related tothe consolidation of client services partially offset by the addition ofbusiness development staff and increased commission expense; (ii) net occupancyexpense decreased

 

20

----

 

$130,000or 21.1% due to a reduction in rent from the relocation of the Company’sheadquarters office and banking office in Century City; (iii) legal servicesexpense increased $275,000 or 151.9% primarily due to activity on thesettlement of a dispute over collateral securing a borrower’s loan; and, (iv)other professional services expense increased $166,000 or 44.5% due to aproductivity consultant engagement and increased costs for audit services.

 

***BALANCE SHEET ANALYSIS***

 

INVESTMENT SECURITIES

 

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

 

21

----

 

**Estimated Fair Values of and Unrealized**

**Gains and Losses on Securities**

 
| ** **                                                                | ** ** | **June 30, 2005**          | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                | ** ** | **Total**                  | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                                                                | ** ** | **amortized**              | ** ** | **unrealized** | ** ** | **unrealized** | ** ** | **fair** | ** ** |
| ** **                                                                | ** ** | **cost**                   | ** ** | **gains** | ** ** | **loss** | ** ** | **value** | ** ** |
| ** **                                                                | ** ** | **(Dollars in thousands)** | ** ** |
| **Available-for-Sale:**                                                   |       |                       |       |   |   |   |   |   |   |
| U.S. Treasury securities                                                  |       | $                          | 698        |   | $ | — |   | $ | 2 |   | $ | 696 |   |
| GNMA-issued/guaranteed mortgage pass  through certificates                |       | 120                        |       | 5 |   | — |   | 125 |   |
| Other U.S. Government and federal agency  securities                      |       | 22,953                     |       | — |   | 146 |   | 22,807 |   |
| FHLMC/FNMA-issued mortgage pass through  certificates                     |       | 14,132                     |       | 63 |   | 7 |   | 14,188 |   |
| CMO’s and REMIC’s issued by U.S.  government-sponsored agencies |       | 31                         |       | — |   | — |   | 31 |   |
| Privately issued corporate bonds, CMO and  REMIC securities               |       | 5,453                      |       | — |   | 13 |   | 5,440 |   |
|                                                                      |       | $                          | 43,387     |   | $ | 68 |   | $ | 168 |   | $ | 43,287 |   |
|                                                                      |       |                       |       |   |   |   |   |   |   |
| FRB and other equity stocks                                               |       | $                          | 3,163      |   | — |   | — |   | $ | 3,163 |   |
|                                                                      |       |                       |       |   |   |   |   |   |   |
| ** **                                                                | ** ** | **June 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                     |       | $                          | 3,048      |   | $ | 11 |   | $ | 4 |   | $ | 3,055 |   |
|                                                                      |       | $                          | 3,048      |   | $ | 11 |   | $ | 4 |   | $ | 3,055 |   |
|                                                                      |       |                       |       |   |   |   |   |   |   |
| ** **                                                                | ** ** | **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 |   |

 

22

----

 

As of June 30, 2005, the Company did not hold securities ofany issuer, other than U.S. government-chartered agencies, the aggregate bookvalue of which exceeded 10% of the Company’s shareholders’ equity.  At June 30, 2005 and December 31, 2004, therewere no securities deemed by management to be other-than-temporarily impaired.

 

LOANPORTFOLIO

 

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

 

**Loan Portfolio Composition**

 
| ** **                                                            | ** ** | **June 30,**               | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------|------------|------------------|------------|
| ** **                                                            | ** ** | **2005**                   | ** ** | **2004**         | ** ** |
| ** **                                                            | ** ** | **Amount**                 | ** ** | **Percent**      | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **                                                            | ** ** | **(Dollars in thousands)** | ** ** |
| Commercial loans - secured and unsecured                              |       | $                          | 94,117     |             | 31         | % | $ | 98,429 |   | 31 | % |
| Real estate loans:                                                    |       |                       |       |             |       |   |   |   |   |
| Secured by commercial real properties                                 |       | 126,081                    |       | 41               | %          | 135,944 |   | 43 | % |
| Secured by one to four family residential  properties                 |       | 9,953                      |       | 3                | %          | 9,405 |   | 3 | % |
| Secured by multifamily residential  properties                        |       | 17,532                     |       | 6                | %          | 18,330 |   | 6 | % |
| Total real estate loans                                               |       | 153,566                    |       | 50               | %          | 163,679 |   | 52 | % |
| Construction and land development                                     |       | 56,843                     |       | 18               | %          | 50,289 |   | 16 | % |
| Consumer installment, home equity and  unsecured loans to individuals |       | 4,203                      |       | 1                | %          | 2,516 |   | 1 | % |
| Total loans outstanding                                               |       | 308,729                    |       | 100              | %          | 314,913 |   | 100 | % |
|                                                                  |       |                       |       |             |       |   |   |   |   |
| Deferred net loan origination fees                                    |       | (1,201                     | )          |             |       | (1,066 | ) |   |   |
| Loans receivable, net                                                 |       | $                          | 307,528    |             |       |   | $ | 313,847 |   |   |   |

 

Total loans outstanding decreased by $6.3million to $307.5 million at June 30, 2005 compared to $313.8 million atDecember 31, 2004 due primarily to more rapid payoffs than funding ofcommercial real estate loans.  Realestate loans secured by commercial real properties decreased $9.9 million from$135.9 million at December 31, 2004 to $126.1 million at June 30, 2005.  The Company has experienced significant pricecompetition, particularly for fixed rates on commercial real estate loans.

 

23

----

 

NONPERFORMINGASSETS

 

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

 

**NonperformingAssets**

 
| ** **                                                                                                                 | ** ** | **June 30,**               | ** ** | **December 31** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|-----------------|------------|
| ** **                                                                                                                 | ** ** | **2005**                   | ** ** | **2004**        | ** ** |
| ** **                                                                                                                 | ** ** | **(Dollars in thousands)** | ** ** |
|                                                                                                                       |       |                       |       |            |       |
| Nonaccrual loans                                                                                                           |       | $                          | 300        |            | $          | 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                                                                                                        |       | 300                        |       | 1,822           |       |
| Other real estate owned                                                                                                    |       | 1,056                      |       | 1,056           |       |
| Other nonperforming assets                                                                                                 |       | —                     |       | —          |       |
| Total nonperforming assets                                                                                                 |       | $                          | 1,356      |            | $          | 2,878 |   |
|                                                                                                                       |       |                       |       |            |       |
| Allowance for credit losses as a percent of  nonaccrual loans                                                              |       | 1382.0                     | %          | 21822.2         | %          |
| Allowance for credit losses as a percent of  nonperforming loans                                                           |       | 1382.0                     | %          | 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             | %          |

 

ALLOWANCEFOR CREDIT LOSSES

 

Provisions for credit losses charged tooperations reflect management’s judgment of the adequacy of the allowance forcredit losses and are determined through periodic analysis of the loanportfolio.  This analysis includes adetailed review of the classification and categorization of problem loans andloans to be charged off; an assessment of the overall quality and collectibilityof the portfolio; and consideration of the loan loss experience, trends inproblem loan concentrations of credit risk, as well as current economicconditions (particularly Southern California). Management, in conjunction****with an outside advisory firm,performs a periodic risk and credit analysis, the results of which are reportedto the Board of Directors.

 

There were no loans charged off duringthe second quarter of 2005.  Loanscharged off during the six months ended June 30, 2005 were $6,000.   This compares to no loans being charged offduring the second quarter of 2004 and $35,000 during the first half of2004.   Recoveries of loans previouslycharged off were $132,000 and $135,000 during the second quarter and first halfof 2005, respectively, compared to $58,000 and $91,000 during the secondquarter and first half of 2004.  See Note4 of Notes to Consolidated Financial Statements.

 

24

----

 

Credit quality is affected by many factors beyond the control of theCompany, including local and national economies, and facts may exist which arenot known to the Company that adversely affect the likelihood of repayment ofvarious loans in the loan portfolio and realization of collateral upon adefault. Accordingly, no assurance can be given that the Company will notsustain loan losses materially in excess of the allowance for credit losses. Inaddition, the Office of the Comptroller of the Currency (“OCC”), as an integralpart of its examination process, periodically reviews the allowance for creditlosses and could require additional provisions for credit losses.

 

DEPOSITS

 

Total deposits were $350.3 million and$313.5 million at June 30, 2005 and December 31, 2004, respectively.  Noninterest-bearing demand deposits increasedto $146.0 million at June 30, 2005 compared to $113.9 million at December 31,2004.  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 June 30, 2005 reflected a normalization following this year-end variabilityas well as deposits that are expected to be transitory.  Money market deposits and savings depositswere $65.9 million and $30.6 million, respectively, at June 30, 2005 comparedto $69.4 million and $32.2 million, respectively, at December 31, 2004.  Interest-bearing demand deposits, which forthe most part are limited to individuals, decreased to $31.3 million at June30, 2005 from $35.0 million at December 31, 2004.  Similar to noninterest-bearing demanddeposits, interest-bearing demand deposits increased significantly at December31, 2004 from the fourth quarter average of $31.7 million, thus the decline atJune 30, 2005 reflected a normalization following the year-end variability.  Time certificates of deposit (“TCDs”)increased to $76.6 million at June 30, 2005 from $63.1 million at December 31,2004 due to an increase in brokered deposits. There were $11.5 million in brokered TCDs at June 30, 2005 compared to$6.9 million at December 31, 2004.

 

During the first half of 2005, the Company supplemented its liquiditywith $7.5 million of brokered time certificates of deposit ranging in term fromthree months to one year.  Additionally,although the Company has priced its retail certificates of deposit to encouragerunoff during the past several years, in the rising rate environmentexperienced during the first quarter of 2005, it has elected to generallymaintain stable rates on its immediately repriceable base of deposits –interest-bearing demand deposits, and savings and money market deposits – andprice new time certificates of deposit to generate growth.

 

25

----

 

OTHER BORROWINGS

 

There wereno other borrowings, consisting of advances from the Federal Home Loan Bank, atJune 30, 2005 compared to $25.9 million at December 31, 2004.   The decline in other borrowings reflectedrepayment at maturity due to the decline in loans receivable and increase indeposits.

 

SHAREHOLDERS’ EQUITY

 

Shareholders’ equity increased from $34.5million at December 31, 2004 to $36.4 million at June 30, 2005 due to theretained earnings for the six months ended June 30, 2005 and the increase inmarket value of interest rate swaps and securities available-for-sale.

 

***CAPITAL ADEQUACY REQUIREMENTS***

 

At June 30, 2005, the Company and the Banks were in compliance with allapplicable regulatory capital requirements and the Banks were “well capitalized”under the Prompt Corrective Action rules of the OCC.  The following table sets forth the regulatorycapital standards for well-capitalized institutions,and the capital ratios for the Company and the Banks, as of June 30, 2005 andDecember 31, 2004.

 

26

----

 

**Regulatory Capital Information**

**of****the National MercantileBancorp and Banks**

 
| ** **                       | ** ** | **Minimum**     | ** ** | ** **      | ** ** | ** **   | ** ** | ** **       | ** ** |
|----------------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|------------------|------------|
| ** **                       | ** ** | **For Capital** | ** ** | **Well**        | ** ** | ** **   | ** ** | ** **       | ** ** |
| ** **                       | ** ** | **Adequacy**    | ** ** | **Capitalized** | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
| ** **                       | ** ** | **Purposes**    | ** ** | **Standards**   | ** ** | **2005**     | ** ** | **2004**         | ** ** |
| **National Mercantile Bancorp:** |       |            |       |            |       |         |       |             |       |
| Tier 1 leverage                  |       | 4.00            | %          | N/A             |       | 11.18        | %          | 9.87             | %          |
| Tier 1 risk-based capital        |       | 4.00            | %          | N/A             |       | 11.88        | %          | 10.39            | %          |
| Total risk-based capital         |       | 8.00            | %          | N/A             |       | 13.85        | %          | 12.42            | %          |
|                             |       |            |       |            |       |         |       |             |       |
| **Mercantile National Bank:**    |       |            |       |            |       |         |       |             |       |
| Tier 1 leverage                  |       | 4.00            | %          | 5.00            | %          | 10.85        | %          | 8.99             | %          |
| Tier 1 risk-based capital        |       | 4.00            | %          | 6.00            | %          | 12.53        | %          | 10.44            | %          |
| Total risk-based capital         |       | 8.00            | %          | 10.00           | %          | 13.78        | %          | 11.60            | %          |
|                             |       |            |       |            |       |         |       |             |       |
| **South Bay Bank, NA:**          |       |            |       |            |       |         |       |             |       |
| Tier 1 leverage                  |       | 4.00            | %          | 5.00            | %          | 10.72        | %          | 9.32             | %          |
| Tier 1 risk-based capital        |       | 4.00            | %          | 6.00            | %          | 10.21        | %          | 9.32             | %          |
| Total risk-based capital         |       | 8.00            | %          | 10.00           | %          | 11.24        | %          | 10.29            | %          |

 

***LIQUIDITY***

 

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

 

The Company’s cash anddue from banks - demand was $19.3 million on June 30, 2005 compared to $14.2million on December 31, 2004.  Due frombanks-interest-bearing was $2.0 million at June 30, 2005 and $2.7 million atDecember 31, 2004, respectively.  Therewas $9.0 million in Federal funds sold at June 30, 2005 compared to no Federalfunds sold at December 31, 2004.  Mercantilehad $5.0 million and South Bay had $12.0 million in Federal funds lines withcorrespondent banks as of June 30, 2005.

 

National Mercantile is a legal entity separate and distinct from theBanks, 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 capitaldistributions from the Banks.  Inaddition to its own operating expenses, National Mercantile is responsible forthe payment of the interest on the outstanding Junior SubordinatedDebentures.  The semiannual interestpayments on the Junior Subordinated Debentures, under the terms of theindenture, are deferrable at National Mercantile’s option, for a period up toten consecutive semiannual payments, but in any event not beyond June 25,2031.   National Mercantile has notdeferred any interest payments.

 

National Mercantile’s cash and due from banks was $56,000 on June 30,2005 compared to $174,000 at December 31, 2004.   Due from banks-interest bearing was $510,000at June 30, 2005 compared to $1.7 million at December 31, 2004.

 

27

----

 

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 under certain circumstances, and with prior regulatory approval,a bank may not pay a dividend if, after so doing, it would be undercapitalized.  A bank’s ability to pay dividends in thefuture is, and could be, further influenced by regulatory policies oragreements and by capital guidelines.

 

Mercantile has a substantialaccumulated deficit and does not anticipate having positive cumulative retainedearnings for the foreseeable future. South Bay had cumulative retained earnings of $2.8 million as of June30, 2005.  Mercantile and South Bay mayfrom time to time be permitted to make capital distributions to NationalMercantile with the consent of the OCC. It is likely that such consent could not be obtained unless thedistributing bank remained “well capitalized” following such distribution.

 

***ASSET LIABILITY MANAGEMENT***

 

The following table shows that theCompany’s cumulative one-year interest rate sensitivity gap indicated an assetsensitive position of $21.4 million at June 30, 2005 compared to a liabilitysensitive 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.

 

28

----

 

Interest rate sensitivity is managed bymatching the repricing opportunities on the Company’s earning assets to thoseon the funding liabilities.  Variousstrategies are used to manage the repricing characteristics of assets and liabilities to ensure that exposure to interest rate fluctuationsis limited within guidelines of acceptable levels of risk-taking.  Hedging strategies, including the terms andpricing of loans and deposits, the use of derivative financial instruments (seeNote 9 to the Consolidated Financial Statements) and managing the deployment ofsecurities are used to reduce mismatches in interest rate repricingopportunities of portfolio assets and their funding sources.  Interest rate risk is measured usingfinancial modeling techniques, including stress tests, to measure the impact ofchanges in interest rates on future earnings. These static measurements do not reflect the results of any projectedactivity and are best used as early indicators of potential interest rateexposures.

 

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

 

29

----

 

**Rate-SensitiveAssets and Liabilities**

 
| ** **                                                               | ** ** | **June 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  |       | $                            | 9,000      |   | $ | — |   | $ | — |   | $ | — |   | $ | 9,000 |   |
| Securities at amortized cost                                             |       | 521                          |       | 14,589 |   | 12,280 |   | 19,045 |   | 46,435 |   |
| Due from banks - interest bearing                                        |       | 2,000                        |       | — |   | — |   | — |   | 2,000 |   |
| FRB and other stock, at cost                                             |       | —                       |       | — |   | — |   | 3,163 |   | 3,163 |   |
| Loans receivable (1)                                                     |       | 237,188                      |       | 18,270 |   | 40,962 |   | 10,808 |   | 307,228 |   |
| Interest rate swaps                                                      |       | —                       |       | — |   | 40,000 |   | 25,000 |   | 65,000 |   |
| Total rate-sensitive assets                                              |       | 248,709                      |       | 32,859 |   | 93,242 |   | 58,016 |   | 432,826 |   |
|                                                                     |       |                         |       |   |   |   |   |   |   |   |   |
| Rate-Sensitive Liabilities: (2)                                          |       |                         |       |   |   |   |   |   |   |   |   |
| Interest bearing deposits:                                               |       |                         |       |   |   |   |   |   |   |   |   |
| Demand, money market and savings                                         |       | 127,733                      |       | — |   | — |   | — |   | 127,733 |   |
| Time certificates of deposit                                             |       | 35,805                       |       | 31,607 |   | 9,126 |   | 42 |   | 76,580 |   |
| Other borrowings                                                         |       | —                       |       | — |   | — |   | — |   | — |   |
| Junior subordinated debentures                                           |       | —                       |       | — |   | — |   | 15,464 |   | 15,464 |   |
| Interest rate swaps                                                      |       | 65,000                       |       | — |   | — |   | — |   | 65,000 |   |
| Total rate-sensitive liabilities                                         |       | 228,538                      |       | 31,607 |   | 9,126 |   | 15,506 |   | 284,777 |   |
| Interest rate-sensitivity gap                                            |       | 20,171                       |       | 1,252 |   | 84,116 |   | 42,510 |   | 148,049 |   |
| Cumulative interest rate-sensitivity gap                                 |       | $                            | 20,171     |   | $ | 21,423 |   | $ | 105,539 |   | $ | 148,049 |   |   |   |
| Cumulative ratio of rate sensitive assets  to rate-sensitive liabilities |       | 109                          | %          | 108 | % | 139 | % | 152 | % |   |   |
|                                                                          |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)     Loans receivable excludes nonaccrual loans.

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

The distribution of other time deposits isbased on scheduled maturities.

 

30

----

*** ***

**Rate-Sensitive Assets and 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 | % |   |   |

 

----

(1)     Loans receivable excludes nonaccrual loans.

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

The distribution of other time deposits isbased on scheduled maturities.

 

# **FACTORSWHICH MAY AFFECT FUTURE OPERATING RESULTS**

 

TheCompany’s results of operations and financial condition are affected by manyfactors, including the following.

 

**Riskfrom changes in interest rates.**

 

Thesuccess of the Company’s business depends, to a large extent, on its netinterest income.  Changes in marketinterest rates can affect net interest income by affecting the spread betweeninterest-earning assets and interest-bearing liabilities.  This

 

31

----

 

maybe due to the different maturities of interest-earning assets andinterest-bearing liabilities, as well as an increase in the general level ofinterest rates.  Changes in marketinterest rates also affect, among other things:

 

•                  The Company’sability to originate loans;

 

•                  The abilityof borrowers to make payments on their loans;

 

•                  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.

 

Interest rates are highly sensitive to many factors, includinggovernmental monetary policies, domestic and international economic andpolitical conditions and other factors beyond the Company’s control.

 

**Riskfrom possible declines in the quality of the Company’s assets.**

 

The Company’s financial condition depends significantly on the qualityof its assets.  While its has developedand implemented 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.

 

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

 

Allowances for credit losses are established against each segment ofthe loan portfolio.  At June 30, 2005,the allowance for credit losses equaled 1.35% of loans receivable and 1382.0%of nonperforming loans.  Althoughmanagement believes that it has established adequate allowances for creditlosses as of June 30, 2005, the credit quality of the Company’s assets isaffected by many factors beyond its control, including local and nationaleconomic conditions, and the possible existence of facts which are notcurrently known which adversely affect the likelihood of repayment of variousloans in the loan portfolio and realization of the collateral upon adefault.  Accordingly, there is noassurance that the Company will not sustain loan losses materially in excess ofthe allowance for credit losses.  Inaddition, the Office of the Comptroller of the Currency, as an integral part ofits examination process, periodically reviews the allowance for credit lossesand could require additional provisions for credit losses.  Material future additions to the allowancefor credit losses may also be necessary due to increases

 

32

----

 

inthe size and changes 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.**

 

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

 

**Because a significant amount ofthe loans are made to borrowers in California, the Company’s operations couldsuffer as a result of local recession or natural disasters in California.**

 

At June 30, 2005, a large majority of the loans outstanding werecollateralized by real properties located in California.  Because of this concentration in California,the Company’s financial position and results of operations have been and areexpected to continue to be influenced by general trends in the Californiaeconomy and its real estate market.  Realestate market declines may adversely affect the values of the properties collateralizingloans.  If the principal balances of theloans, together with any primary financing on the mortgaged properties, equalor exceed the value of the mortgaged properties, the Company could incur higherlosses on sales of properties collateralizing foreclosed loans.  In addition, California historically has beenvulnerable to certain natural disaster risks, such as earthquakes anderosion-caused mudslides, which are not typically covered by the standardhazard insurance policies maintained by borrowers.  Uninsured disasters may adversely impact theability to recover losses on properties affected by such disasters andadversely impact the Company’s results of operations.

 

**The Company’s business is verycompetitive.**

 

There is intense competition in Southern California and elsewhere inthe United States for banking customers. The Company experiences competition for deposits from many sources,including credit unions, insurance companies and money market and other mutualfunds, as well as other commercial banks and savings institutions.  The Company competes for loans and depositsprimarily with other commercial banks, mortgage companies, commercialfinance companies and savings institutions. In recent years out-of-state financial institutions have entered theCalifornia market, which has also increased competition.  Many of the competitors have greaterfinancial strength, marketing capability and name recognition, and operate on astatewide or nationwide basis.  Inaddition, recent developments in technology and mass marketing have permittedlarger companies to market loans more aggressively to small businesscustomers.  Such advantages may give thecompetitors 

 

33

----

 

opportunitiesto realize greater efficiencies and economies of scale than the Companycan.  There is no assurance that theCompany will be able to compete effectively against its competition.

 

**The Company’s business is heavilyregulated.**

 

Both National Mercantile as a bank holding company, and Mercantile andSouth Bay, as national banks, are subject to significant governmentalsupervision and regulation, which is intended primarily for the protection ofdepositors.  Statutes and regulationsaffecting the Company may be changed at any time, and the interpretation ofthese statutes and regulations by examining authorities also may change.  There is no assurance that future changes inapplicable statutes and regulations or in their interpretation will not adverselyaffect the Company’s business.

 

**Goodwill is evaluated annually and any impairment must berecorded as a charge to earnings**.

 

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

 

TheCompany has goodwill of $3.2 million in connection with the South Bayacquisition in December 2001.  During thefourth quarter of 2004, the required impairment tests of goodwill werecompleted.  The tests determined thatgoodwill was not considered impaired.  Noassurance can be given that goodwill will not become impaired in the future.

 

**The Company annually evaluates whether the deferred tax assetwill be realized and must establish a valuation allowance if necessary toreduce it to its realizable value.**

 

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

 

•                  Futureearnings are likely;

 

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

 

Avaluation allowance may be established to reduce the deferred tax asset to itsrealizable value.  The determination ofwhether a valuation allowance is necessary involves considering the positiveand negative factors related to whether the deferred tax asset is more likelythan not to be realized.  Any adjustmentrequired to the valuation allowance is coupled with a related entry

 

34

----

 

to income taxexpense.  A charge to earnings will bemade in the event that a valuation allowance to the deferred tax asset isnecessary.  No such valuation allowanceexisted at June 30, 2005.

 

CAUTIONARY NOTE REGARDINGFORWARD-LOOKING STATEMENTS

 

This reportcontains 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.

 

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

 

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

 

TheCompany maintains disclosure controls and procedures (as defined in ExchangeAct Rule 13a-15(e)) that are designed to assure that information required to bedisclosed in its Exchange Act reports is recorded, processed, summarized andreported within the time periods specified in the Securities and ExchangeCommission’s rules and forms, and that such information is accumulated and communicatedto management, including the Chief Executive Officer and Chief FinancialOfficer, as appropriate, to allow timely decisions regarding requireddisclosures.

 

Indesigning and evaluating the disclosure controls and procedures, managementrecognizes that any controls and procedures, no matter how well designed andoperated, can provide reasonable assurance only of achieving the desiredcontrol

 

35

----

 

objectives,and management necessarily is required to apply its judgment in weighting thecosts and benefits of possible new or different controls and procedures.  Limitations are inherent in all controlsysytems, so no evaluation of controls can provide absolute assurance that allcontrol issues and any fraud within the company have been detected.

 

Asrequired by Exchange Act Rule 13a-15(b), as of the end of the period covered bythis report the Company, under the supervision and with the participation ofour Chief Executive Officer and Chief Financial Officer, evaluated theeffectiveness of the Company’s disclosure controls and procedures.  Based on this evaluation, our Chief ExecutiveOfficer and Chief financial Officer concluded that the Company’s disclosurecontrols and procedures were effective as of that date.

 

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

 

36

----

 

**PARTII—OTHER INFORMATION**

 

***Item 1.***       LEGAL PROCEEDINGS

 

None.

 

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

 

None.

 

 

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

 

None.

 

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

 

The Annual Meeting of Shareholders of the Company was held on May 19,2005 to elect the members of the Company’s Board of Directors and vote on twoadditional proposals.  The number of votesfor each nominee is set forth below:

 
| **Name**                   | ** ** | **Votes For** | ** ** | **Votes  Withheld** | ** ** |
|----------------------------|------------|---------------|------------|---------------------|------------|
|                       |       |          |       |                |       |
| Donald E. Benson           |       | 2,553,394     |       | 26,336              |       |
|                       |       |          |       |                |       |
| Joseph N. Cohen            |       | 2,514,198     |       | 65,532              |       |
|                       |       |          |       |                |       |
| Robert E. Gipson           |       | 2,553,394     |       | 26,336              |       |
|                       |       |          |       |                |       |
| W. Douglas Hile            |       | 2,553,394     |       | 26,336              |       |
|                       |       |          |       |                |       |
| Antoinette Hubenette, M.D. |       | 2,553,394     |       | 26,336              |       |
|                       |       |          |       |                |       |
| Scott A. Montgomery        |       | 2,553,394     |       | 26,336              |       |
|                       |       |          |       |                |       |
| Dion G. Morrow             |       | 2,553,394     |       | 26,336              |       |
|                       |       |          |       |                |       |
| Carl R. Terzian            |       | 2,553,394     |       | 26,336              |       |
|                       |       |          |       |                |       |
| Robert E. Thomson          |       | 2,553,394     |       | 26,336              |       |

 

In addition, the following proposals were voted on at the annualmeeting:

 

Proposal to approve the Company’s 2005 Stock Incentive Plan.

 
| **For**   | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Broker Non-Vote** | ** ** |
|-----------|------------|-------------|------------|-------------|------------|---------------------|------------|
|      |       |        |       |        |       |                |       |
| 1,749,543 |       | 74,949      |       | 11,924      |       | 743,314             |       |

 

37

----

 

Proposal to approve an amendment to the Company’s Amendedand Restate Articles of Incorporation to amend the terms of the Series APreferred Stock.

 
| **For**   | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Broker Non-Vote** | ** ** |
|-----------|------------|-------------|------------|-------------|------------|---------------------|------------|
|      |       |        |       |        |       |                |       |
| 1,777,210 |       | 32,026      |       | 27,180      |       | 743,314             |       |

 

***Item 5.******       OTHERINFORMATION***

 

None.

 

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

 

3.1Certificate of Amendment of the Amended and Restated Articles of Incorporationof National Mercantile Bancorp

10.1 NationalMercantile Bancorp 2005 Stock Incentive Plan (1)

10.2 Form ofIncentive Stock Option Agreement (1)

10.3 Form ofNon-Qualified Stock Option Agreement (1)

31.1 Certification of Scott A. Montgomery ondisclosure controls

31.2 Certification of David R. Brown ondisclosure controls

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

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

 

----

(1)          Filed as an exhibit to National MercantileBancorp’s Registration Statement on Form S-8 Registration no. 333-125220

 

 

**SIGNATURES**

 

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

 
|   |             | **NATIONAL  MERCANTILE BANCORP**                       |
|--------|------------------|--------------------------------------------------------|
|   |             | (Registrant)                                           |
|   |             |                                                   |   |   |
| DATE:  | August 12,  2005 |                                                   | /s/ | Scott A. Montgomery |   |
|   |             | **Scott A.  Montgomery**                               |
|   |             | Chief  Executive Officer                               |
|   |             |                                                   |   |   |
| DATE:  | August 12,  2005 |                                                   | /s/ | David R. Brown |   |
|   |             | **David R.  Brown**                                    |
|   |             | Principal  Financial and Principal Accounting  Officer |

 

38

----