** **

**U.S. SECURITIES AND EXCHANGE COMMISSION**

 

**WASHINGTON, D.C. 20549**

 

**FORM 10-QSB**

 

**QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended September 30,2003 Commission File Number: 0-15982**

 

**NATIONAL MERCANTILE BANCORP**

(Exact name ofsmall business issuer as specified in its charter)

** **

| **California**                                                                                      |   | **95-3819685**                        |
|-----------------------------------------------------------------------------------------------------|--------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization)                                     |   | (I.R.S. Employer  Identification No.) |
|                                                                                                |   |                                  |
| **1840 Century Park East, Los Angeles,  California      90067**       |
| (Address of principal executive  offices)        (Zip Code) |

 

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

 

Indicate by check markwhether the issuer (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months(or for such shorter period that the registrant was required to file suchreports), and (2) has been subject to such filing requirements for the past 90days.

 

YES  ý     NO  o

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

 

The number of sharesoutstanding of the issuer’s Common Stock, no par value, as of November 12, 2003was 2,732,925.

 

 

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| PART I – FINANCIAL INFORMATION   |   |
|---------------------------------------|--------|
|                                  |   |
| *Item 1.   Financial Statements* |   |

 

2

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**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

 
|                                                                                                                                                                                               |   | **September 30,  2003**    |       | **December 31,  2002** |       |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------|------------|------------------------|------------|
|                                                                                                                                                                                               |   | **(Unaudited)**            | ** ** |                   | ** ** |
|                                                                                                                                                                                               |   | **(Dollars in thousands)** | ** ** |
| ASSETS                                                                                                                                                                                             |   |                       |       |                   |       |
| Cash and due from banks-demand                                                                                                                                                                     |   | $                          | 22,590     |                   | $          | 18,876 |   |
| Federal funds sold and securities purchased under  agreements to resell                                                                                                                            |   | 42,000                     |       | 18,700                 |       |
| Cash and cash equivalents                                                                                                                                                                          |   | 64,590                     |       | 37,576                 |       |
| Securities available-for-sale, at fair value;  aggregate amortized cost of $31,250 and $25,824 at September 30, 2003 and  December 31, 2002, respectively                                          |   | 31,314                     |       | 26,170                 |       |
| Securities held to maturity                                                                                                                                                                        |   | 4,869                      |       | —                 |       |
| Due from banks-interest bearing                                                                                                                                                                    |   | 2,228                      |       | 325                    |       |
| FRB and other stock, at cost                                                                                                                                                                       |   | 1,869                      |       | 2,018                  |       |
| Loans receivable                                                                                                                                                                                   |   | 247,465                    |       | 272,323                |       |
| Allowance for credit losses                                                                                                                                                                        |   | (3,588                     | )          | (4,846                 | )          |
| Net loans receivable                                                                                                                                                                               |   | 243,877                    |       | 267,477                |       |
|                                                                                                                                                                                               |   |                       |       |                   |       |
| Premises and equipment, net                                                                                                                                                                        |   | 5,552                      |       | 5,836                  |       |
| Other real estate owned                                                                                                                                                                            |   | 1,000                      |       | 1,000                  |       |
| Deferred tax asset                                                                                                                                                                                 |   | 7,741                      |       | 7,984                  |       |
| Goodwill                                                                                                                                                                                           |   | 2,174                      |       | 2,174                  |       |
| Core deposit intangibles, net                                                                                                                                                                      |   | 1,909                      |       | 2,077                  |       |
| Accrued interest receivable and other assets                                                                                                                                                       |   | 3,343                      |       | 2,748                  |       |
| Total assets                                                                                                                                                                                       |   | $                          | 370,466    |                   | $          | 355,385 |   |
|                                                                                                                                                                                               |   |                       |       |                   |       |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                                                                                          |   |                       |       |                   |       |
| Deposits:                                                                                                                                                                                          |   |                       |       |                   |       |
| Noninterest-bearing demand                                                                                                                                                                         |   | $                          | 127,421    |                   | $          | 107,580 |   |
| Interest-bearing demand                                                                                                                                                                            |   | 28,117                     |       | 30,465                 |       |
| Money market                                                                                                                                                                                       |   | 59,777                     |       | 43,134                 |       |
| Savings                                                                                                                                                                                            |   | 43,423                     |       | 42,182                 |       |
| Time certificates of deposit:                                                                                                                                                                      |   |                       |       |                   |       |
| $ 100,000 or more                                                                                                                                                                                  |   | 25,674                     |       | 43,006                 |       |
| Under $100,000                                                                                                                                                                                     |   | 31,013                     |       | 32,358                 |       |
| Total deposits                                                                                                                                                                                     |   | 315,425                    |       | 298,725                |       |
|                                                                                                                                                                                               |   |                       |       |                   |       |
| Federal funds purchased and securities sold under  agreements to repurchase                                                                                                                        |   | 397                        |       | 1,476                  |       |
| Other borrowings                                                                                                                                                                                   |   | 7,500                      |       | 7,500                  |       |
| Junior subordinated deferrable interest debentures                                                                                                                                                 |   | 15,464                     |       | —                 |       |
| Accrued interest payable and other liabilities                                                                                                                                                     |   | 738                        |       | 1,950                  |       |
| Total liabilities                                                                                                                                                                                  |   | 339,524                    |       | 309,651                |       |
|                                                                                                                                                                                               |   |                       |       |                   |       |
| Guaranteed preferred beneficial interests in the  Company’s junior subordinated deferrable interest debentures, net                                                                           |   | —                     |       | 14,530                 |       |
|                                                                                                                                                                                               |   |                       |       |                   |       |
| Shareholders’ equity:                                                                                                                                                                         |   |                       |       |                   |       |
| Preferred stock, no par value - authorized  1,000,000 shares:                                                                                                                                      |   |                       |       |                   |       |
| Series A non-cumulative convertible perpetual  preferred stock; authorized 990,000 shares; outstanding 732,785 shares and  734,985 shares at September 30, 2003 and December 31 2002, respectively |   | 5,985                      |       | 6,003                  |       |
| Series B non-cumulative convertible perpetual  preferred stock; authorized 1,000 shares; outstanding 1,000 shares                                                                                  |   | 1,000                      |       | 1,000                  |       |
| Common stock, no par value; authorized 10,000,000  shares; outstanding 2,702,529 and 2,679,544 shares at September 30, 2003 and  December 31, 2002, respectively                                   |   | 38,168                     |       | 38,054                 |       |
| Accumulated deficit                                                                                                                                                                                |   | (14,248                    | )          | (14,055                | )          |
| Accumulated other comprehensive income                                                                                                                                                             |   | 37                         |       | 202                    |       |
| Total shareholders’ equity                                                                                                                                                                    |   | 30,942                     |       | 31,204                 |       |
| Total liabilities and shareholders’ equity                                                                                                                                                    |   | $                          | 370,466    |                   | $          | 355,385 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

3

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** **

**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
|                                                                                                                                                                                                                                      |   | **For  the Three Months Ended  September 30,**      |       | **For  the Nine Months Ended  September 30,** |       |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------|------------|-----------------------------------------------|------------|
|                                                                                                                                                                                                                                      |   | **2003**                                            |       | **2002**                                      |       | **2003** |   | **2002** |   |
|                                                                                                                                                                                                                                      |   | **(Dollars  in thousands,  except per share data)** |       |
| Interest income:                                                                                                                                                                                                                          |   |                                                | ** ** |                                          | ** ** |   | ** ** |   | ** ** |
| Loans, including fees                                                                                                                                                                                                                     |   | $                                                   | 3,914      |                                          | $          | 4,363 |   | $ | 12,121 |   | $ | 13,115 |   |
| Securities                                                                                                                                                                                                                                |   | 251                                                 |       | 401                                           |       | 660 |   | 1,331 |   |
| Federal funds sold and securities purchased under  agreements to resell                                                                                                                                                                   |   | 92                                                  |       | 105                                           |       | 268 |   | 361 |   |
| Interest bearing deposits                                                                                                                                                                                                                 |   | 5                                                   |       | —                                        |       | 5 |   | — |   |
|                                                                                                                                                                                                                                      |   |                                                |       |                                          |       |   |   |   |   |
| Total interest income                                                                                                                                                                                                                     |   | 4,262                                               |       | 4,869                                         |       | 13,054 |   | 14,807 |   |
| Interest expense:                                                                                                                                                                                                                         |   |                                                |       |                                          |       |   |   |   |   |
| Interest-bearing demand                                                                                                                                                                                                                   |   | 21                                                  |       | 86                                            |       | 110 |   | 243 |   |
| Money market and savings                                                                                                                                                                                                                  |   | 181                                                 |       | 388                                           |       | 736 |   | 1,087 |   |
| Time certificates of deposit:                                                                                                                                                                                                             |   |                                                |       |                                          |       |   |   |   |   |
| $ 100,000 or more                                                                                                                                                                                                                         |   | 163                                                 |       | 172                                           |       | 429 |   | 673 |   |
| Under $100,000                                                                                                                                                                                                                            |   | 138                                                 |       | 357                                           |       | 657 |   | 1,117 |   |
| Total interest expense on deposits                                                                                                                                                                                                        |   | 503                                                 |       | 1,003                                         |       | 1,932 |   | 3,120 |   |
| Federal funds purchased and securities sold under  agreements to repurchase                                                                                                                                                               |   | 3                                                   |       | 21                                            |       | 14 |   | 116 |   |
| Junior subordinated deferrable interest debentures                                                                                                                                                                                        |   | 228                                                 |       | —                                        |       | 228 |   | — |   |
| Other borrowings                                                                                                                                                                                                                          |   | 89                                                  |       | 92                                            |       | 267 |   | 388 |   |
| Total interest expense                                                                                                                                                                                                                    |   | 823                                                 |       | 1,116                                         |       | 2,441 |   | 3,624 |   |
|                                                                                                                                                                                                                                      |   |                                                |       |                                          |       |   |   |   |   |
| Net interest income before provision for credit  losses                                                                                                                                                                                   |   | 3,439                                               |       | 3,753                                         |       | 10,613 |   | 11,183 |   |
| Provision for credit losses                                                                                                                                                                                                               |   | 10                                                  |       | 1,525                                         |       | 1,265 |   | 1,825 |   |
| Net interest income after provision for credit  losses                                                                                                                                                                                    |   | 3,429                                               |       | 2,228                                         |       | 9,348 |   | 9,358 |   |
| Other operating income:                                                                                                                                                                                                                   |   |                                                |       |                                          |       |   |   |   |   |
| Net gain on sale of securities available-for-sale                                                                                                                                                                                         |   | —                                              |       | —                                        |       | 100 |   | — |   |
| International services                                                                                                                                                                                                                    |   | 19                                                  |       | 13                                            |       | 34 |   | 32 |   |
| Investment division                                                                                                                                                                                                                       |   | 22                                                  |       | 20                                            |       | 66 |   | 62 |   |
| Deposit-related and other customer services                                                                                                                                                                                               |   | 356                                                 |       | 320                                           |       | 977 |   | 941 |   |
| Gain (loss) on sale of OREO/fixed assets                                                                                                                                                                                                  |   | —                                              |       | —                                        |       | (61 | ) | — |   |
| Total other operating income                                                                                                                                                                                                              |   | 397                                                 |       | 353                                           |       | 1,116 |   | 1,035 |   |
| Other operating expenses:                                                                                                                                                                                                                 |   |                                                |       |                                          |       |   |   |   |   |
| Salaries and related benefits                                                                                                                                                                                                             |   | 1,792                                               |       | 1,730                                         |       | 5,462 |   | 5,135 |   |
| Net occupancy                                                                                                                                                                                                                             |   | 333                                                 |       | 348                                           |       | 1,006 |   | 1,070 |   |
| Furniture and equipment                                                                                                                                                                                                                   |   | 112                                                 |       | 101                                           |       | 346 |   | 315 |   |
| Printing and communications                                                                                                                                                                                                               |   | 143                                                 |       | 126                                           |       | 405 |   | 437 |   |
| Insurance and regulatory assessments                                                                                                                                                                                                      |   | 97                                                  |       | 89                                            |       | 292 |   | 267 |   |
| Client services                                                                                                                                                                                                                           |   | 129                                                 |       | 155                                           |       | 449 |   | 601 |   |
| Computer data processing                                                                                                                                                                                                                  |   | 261                                                 |       | 224                                           |       | 726 |   | 736 |   |
| Legal services                                                                                                                                                                                                                            |   | 122                                                 |       | 72                                            |       | 382 |   | 452 |   |
| Other professional services                                                                                                                                                                                                               |   | 206                                                 |       | 98                                            |       | 613 |   | 415 |   |
| Amortization of core deposit intangible                                                                                                                                                                                                   |   | 56                                                  |       | —                                        |       | 168 |   | — |   |
| Promotion and other expenses                                                                                                                                                                                                              |   | 41                                                  |       | 87                                            |       | 263 |   | 284 |   |
|                                                                                                                                                                                                                                      |   |                                                |       |                                          |       |   |   |   |   |
| Total other operating expenses                                                                                                                                                                                                            |   | 3,292                                               |       | 3,030                                         |       | 10,112 |   | 9,712 |   |
| Income before income tax provision and minority  interest                                                                                                                                                                                 |   | 534                                                 |       | (449                                          | )          | 352 |   | 681 |   |
|                                                                                                                                                                                                                                      |   |                                                |       |                                          |       |   |   |   |   |
| Minority interest in the Company’s income of the:                                                                                                                                                                                    |   |                                                |       |                                          |       |   |   |   |   |
| Guaranteed preferred beneficial interests in the  Company’s junior subordinated deferrable interest debentures, net                                                                                                                  |   | —                                              |       | 380                                           |       | 456 |   | 1,153 |   |
| Series A Preferred Stock of South Bay Bank, N.A.                                                                                                                                                                                          |   | —                                              |       | 53                                            |       | — |   | 159 |   |
|                                                                                                                                                                                                                                      |   |                                                |       |                                          |       |   |   |   |   |
| Income (loss) before income tax (benefit) provision                                                                                                                                                                                       |   | 534                                                 |       | (882                                          | )          | (104 | ) | (631 | ) |
|                                                                                                                                                                                                                                      |   |                                                |       |                                          |       |   |   |   |   |
| Income tax (benefit) provision                                                                                                                                                                                                            |   | 242                                                 |       | (340                                          | )          | 26 |   | (202 | ) |
| Net income (loss                                                                                                                                                                                                                          |   | $                                                   | 292        |                                          | $          | (542 | ) | $ | (130 | ) | $ | (429 | ) |
| Income (loss) available to common shareholders (net  income (loss) less accretion of discount of minority interest in subsidiary  preferred stock of $80,000 and $231,000 for the three months and nine months  ended September 30, 2002) |   | $                                                   | 292        |                                          | (622       | ) | $ | (130 | ) | (660 | ) |
| Loss per share:                                                                                                                                                                                                                           |   |                                                |       |                                          |       |   |   |   |   |
| Basic                                                                                                                                                                                                                                     |   | $                                                   | 0.11       |                                          | $          | (0.38 | ) | $ | (0.05 | ) | $ | (0.40 | ) |
| Diluted                                                                                                                                                                                                                                   |   | $                                                   | 0.07       |                                          | $          | (0.38 | ) | $ | (0.05 | ) | $ | (0.40 | ) |

 

Seeaccompanying notes to consolidated financial statements.

 

4

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**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
|                                                                                        |   | **For  the Nine Months Ended September 30,** |   |
|---------------------------------------------------------------------------------------------|--------|----------------------------------------------|--------|
|                                                                                        |   | **2003**                                     |   | **2002** |   |
|                                                                                        |   | **(Dollars  in thousands)**                  |   |
| Cash flows from operating activities:                                                       |   |                                         |   |   |   |
| Net income (loss)                                                                           |   | $                                            | (130   | ) | $ | (429 | ) |
| Adjustments to reconcile net income to net cash  used in operating activities:              |   |                                         |   |   |   |
| Depreciation and amortization                                                               |   | 362                                          |   | 350 |   |
| Provision for credit losses                                                                 |   | 1,265                                        |   | 1,825 |   |
| Gain on sale of securities available for sale                                               |   | (100                                         | )      | — |   |
| Loss on sales of OREO                                                                       |   | 61                                           |   | — |   |
| Net amortization of premium on securities  available-for-sale                               |   | 161                                          |   | 133 |   |
| Net amortization of core deposit intangible                                                 |   | 168                                          |   | — |   |
| Net amortization of premium (discount) on loans  purchased                                  |   | 204                                          |   | 267 |   |
| Decrease in accrued interest receivable and other  assets                                   |   | 632                                          |   | 793 |   |
| Decrease in accrued interest payable and other  liabilities                                 |   | (1,212                                       | )      | (1,699 | ) |
|                                                                                        |   |                                         |   |   |   |
| Net cash provided by operating activities                                                   |   | 1,411                                        |   | 1,240 |   |
| Cash flows from investing activities:                                                       |   |                                         |   |   |   |
| Purchase of securities available-for-sale                                                   |   | (36,334                                      | )      | (7,002 | ) |
| Proceeds from sales of securities  available-for-sale                                       |   | 2,757                                        |   | — |   |
| Proceeds from repayments and maturities of  securities available-for-sale                   |   | 21,321                                       |   | 18,199 |   |
| Proceeds from sales of OREO                                                                 |   | 474                                          |   | — |   |
| Loan originations and principal collections, net                                            |   | 21,597                                       |   | (7,423 | ) |
| Redemption of Federal Reserve stock and other stocks                                        |   | 149                                          |   | 314 |   |
| Purchases of premises and equipment                                                         |   | (78                                          | )      | (191 | ) |
|                                                                                        |   |                                         |   |   |   |
| Net cash provided by investing activities                                                   |   | 9,886                                        |   | 3,897 |   |
| Cash flows from financing activities:                                                       |   |                                         |   |   |   |
| Net increase in demand deposits, money market and  savings accounts                         |   | 35,377                                       |   | 9,186 |   |
| Net decrease in time certificates of deposit                                                |   | (18,677                                      | )      | (20,939 | ) |
| Net decrease in securities sold under agreements to  repurchase and federal funds purchased |   | (1,079                                       | )      | (1,416 | ) |
| Net decrease in other borrowings                                                            |   | —                                       |   | (10,000 | ) |
| Dividends paid on subsidiary preferred  stock                                               |   | —                                       |   | (106 | ) |
| Net proceeds from exercise of stock options                                                 |   | 96                                           |   | 56 |   |
|                                                                                        |   |                                         |   |   |   |
| Net cash provided by (used in) financing activities                                         |   | 15,717                                       |   | (23,219 | ) |
| Net increase in cash and cash equivalents                                                   |   | 27,014                                       |   | (18,082 | ) |
| Cash and cash equivalents, January 1                                                        |   | 37,576                                       |   | 52,093 |   |
|                                                                                        |   |                                         |   |   |   |
| Cash and cash equivalents, September 30                                                     |   | $                                            | 64,590 |   | $ | 34,011 |   |
|                                                                                        |   |                                         |   |   |   |
| Supplemental disclosures of cash flow information:                                          |   |                                         |   |   |   |
| Cash paid for Interest                                                                      |   | $                                            | 2,825  |   | $ | 3,949 |   |
| Transfers to OREO from loans receivable, net                                                |   | $                                            | 535    |   | $ | — |   |

 

Seeaccompanying notes to consolidated financial statements.

 

5

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**NATIONALMERCANTILE BANCORP AND SUBSIDIARIES**

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

 

NOTE1—BASIS OF PRESENTATION AND MANAGEMENT REPRESENTATIONS

 

The unauditedconsolidated financial statements include the accounts of National MercantileBancorp (the ‘‘Company’’) and its wholly owned subsidiaries, MercantileNational Bank and South Bay Bank, N.A.  The Company adopted FASB Interpretation No. 46 Consolidation ofVariable Interest Entities effective July 1, 2003 and accordingly NationalMercantile Capital Trust I is not included in the consolidated balance sheet atSeptember 30, 2003 or the consolidated statement of operation for the threemonths then ended.   The unauditedconsolidated financial statements reflect all interim adjustments, which are ofa normal recurring nature and which, in management’s opinion, are necessary forthe fair presentation of the Company’s consolidated financial position andresults of operations and cash flows for such interim periods. The results forthe three and nine months ended September 30, 2003 are not necessarilyindicative of the results expected for any subsequent period or for the fullyear ending December 31, 2003. The unaudited consolidated financial statementsshould be read in conjunction with the audited consolidated financialstatements included in the Company’s Annual Report on Form 10-KSB for the yearended December 31, 2002.

 

In December 2002 theFinancial Accounting Standards Board issued Statement of Financial AccountingStandards No. 148, (“SFAS No. 148”), Accounting for Stock-BasedCompensation-Transition and Disclosure. SFAS No. 148 amends Statement of Financial Accounting Standards No. 123,(“SFAS No. 123”), Accounting for Stock-Based Compensation, to providealternative methods of transition for a voluntary change to the fair valuebased method of accounting for stock-based employee compensation.  In addition, SFAS No.148 amends thedisclosure requirements of SFAS No. 123 to require prominent disclosures inboth annual and interim financial statements about the method of accounting forstock-based employee compensation and the effect of the method used on reportedresults.  The transition guidance andannual disclosure provisions are effective for fiscal years ending afterDecember 15, 2002.  The interimdisclosure provisions are effective for financial reports containing financialstatements for interim periods beginning after December 15, 2002. The Companyadopted the provisions of SFAS No. 148 effective in the first quarter of 2003.

 

The estimated per shareweighted average fair value of options granted was $4.92 and $4.04 for thethree months ended September 30, 2003 and 2002, respectively.  The estimated per share weighted averagefair value of options granted was $4.78 and $3.89 for the nine months endedSeptember 30, 2003 and 2002, respectively. The Company applies Accounting Principles Board Opinion No. 25 andrelated Interpretations in accounting for the stock incentive plans.  SFAS No. 123, Accounting for

 

6

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Stock-Based Compensation, encourages, but does not require, companiesto record compensation cost for stock-based employee compensation plans at fairvalue.  Accordingly, no compensationcost has been recognized for the options. Had compensation cost for the options granted been determined based onthe fair value at the grant dates for awards consistent with the method of SFASNo. 123, the Company’s net income for the three months ended September 30, 2003and 2002 and the nine months ended September 30, 2003 and 2002 would havedecreased by $28,000 and $23,000, and $93,000 and $68,000 respectively.  Basic and diluted earnings per share wouldhave decreased by $0.01 for the three months ended September 30, 2003. Basicand diluted loss per share would have increased by $0.03 for the nine monthsended September 30, 2003.  Basic anddiluted loss per share would have increased by $0.01 for the three months endedSeptember 30, 2002 and by $0.04 for the nine months ended September 30, 2002.

 

The fair values ofoptions granted during the three months ended September 30, 2003 and 2002 wereestimated on the date of grant using the Black-Scholes option-pricing modelwith the following weighted-average assumptions used: 2003— no dividend yield,expected volatility of 59%, risk-free interest rate of 4.05%, and an expectedlife of 10 years; 2002— no dividend yield, expected volatility of 64%,risk-free interest rate of 3.62%, and an expected life of 10 years.

 

NOTE2—EARNINGS PER SHARE

 

Basic earnings or lossper share is computed using the weighted average number of common sharesoutstanding during the period.  Theweighted average number of common shares outstanding used in computing basicearnings per share and diluted earnings per share for the three months endedSeptember 30, 2003 was 2,700,934 and 4,402,571, respectively.  The weighted average number of common sharesoutstanding used in computing basic and diluted loss per share for the threemonths ended September 30, 2002 was 1,637,991. The weighted average number of common shares outstanding used incomputing basic and diluted loss per share for the nine months ended September30, 2003 and 2002 was 2,694,670 and 1,632,242, respectively. Common shareequivalents have not been included in the loss per share computation as theyare anti-dilutive.

 

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

 

7

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|                                              |   | **Earnings  available to  shareholders** |   | **Weighted  Average  Shares** |      | **Per  share  amount** |   |
|---------------------------------------------------|--------|------------------------------------------|--------|-------------------------------|-----------|------------------------|--------|
|                                              |   | **(in  thousands)**                      |   |                          |      |                   |   |
| *For the three months ended September  30, 2003:* |   |                                     |   |                          |      |                   |   |
| Basic earnings per share                          |   | $                                        | 292    |                          | 2,700,935 |                   | $      | 0.11 |   |
|                                              |   |                                     |   |                          |      |                   |   |
| Effect of diultive securities:                    |   |                                     |   |                          |      |                   |   |
| Options                                           |   |                                     |   | 72,354                        |      |                   |   |
| Convertible preferred stock                       |   |                                     |   | 1,629,282                     |      |                   |   |
| Diluted earnings per share                        |   | 292                                      |   | 4,402,571                     |      | $                      | 0.07   |   |
|                                              |   |                                     |   |                          |      |                   |   |
| *For the three months ended  September 30, 2002:* |   |                                     |   |                          |      |                   |   |
| Basic and diluted loss per share                  |   | $                                        | (622   | )                             | 1,637,991 |                   | $      | (0.38 | ) |
|                                              |   |                                     |   |                          |      |                   |   |
| *For the nine months ended  September 30, 2003:*  |   |                                     |   |                          |      |                   |   |
| Basic and diluted loss per share                  |   | $                                        | (130   | )                             | 2,694,670 |                   | $      | (0.05 | ) |
|                                              |   |                                     |   |                          |      |                   |   |
| *For the nine months ended  September 30, 2002:*  |   |                                     |   |                          |      |                   |   |
| Basic and diluted loss per share                  |   | $                                        | (660   | )                             | 1,632,242 |                   | $      | (0.40 | ) |

 

NOTE 3—CASH AND CASH EQUIVALENTS

 

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

 

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 and loans to be charged off; an assessment of the overall quality andcollectibility of the portfolio; and consideration of the loan loss experience,trends in problem loan concentrations of credit risk, as well as current andexpected future economic conditions (particularly Southern California).Management performs a periodic risk and credit analysis, the results of whichare reported to the Board of Directors.

 

8

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

 

**Analysis of Changes in Allowance for CreditLosses**

 
|                                                     |   | **Three  months ended**     |       | **Nine  months ended**      |       |
|----------------------------------------------------------|--------|-----------------------------|------------|-----------------------------|------------|
|                                                     |   | **September  30,  2003**    |       | **September  30,  2002**    |       | **September  30,  2003** |   | **September  30,  2002** |   |
|                                                     |   | **(Dollars  in thousands)** |       | **(Dollars  in thousands)** |       |
|                                                     |   |                        | ** ** |                        | ** ** |   | ** ** |   | ** ** |
| Balance, beginning of period                             |   | $                           | 3,452      |                        | $          | 5,374 |   | $ | 4,846 |   | $ | 6,542 |   |
| Loans charged off:                                       |   |                        |       |                        |       |   |   |   |   |
| Real estate construction and land development            |   | —                      |       | —                      |       | — |   | 31 |   |
| Commercial loans:                                        |   |                        |       |                        |       |   |   |   |   |
| Secured by one to four family residential  properties    |   | (7                          | )          | —                      |       | 31 |   | — |   |
| Secured by commercial real properties                    |   | —                      |       | 44                          |       | 75 |   | 44 |   |
| Other - secured and unsecured                            |   | 1                           |       | 2,065                       |       | 2,698 |   | 3,807 |   |
| Consumer installment and unsecured loans to  individuals |   | 13                          |       | 50                          |       | 46 |   | 81 |   |
|                                                     |   |                        |       |                        |       |   |   |   |   |
| Total loans charged-off                                  |   | 7                           |       | 2,159                       |       | 2,850 |   | 3,963 |   |
|                                                     |   |                        |       |                        |       |   |   |   |   |
| Recoveries of loans previously charged off:              |   |                        |       |                        |       |   |   |   |   |
| Real estate construction and land development            |   | —                      |       | —                      |       | — |   | 191 |   |
| Commercial loans:                                        |   |                        |       |                        |       |   |   |   |   |
| Secured by commercial real properties                    |   | 13                          |       | —                      |       | 13 |   | — |   |
| Other - secured and unsecured                            |   | 114                         |       | 12                          |       | 247 |   | 107 |   |
| Consumer installment and unsecured loans to  individuals |   | 6                           |       | 4                           |       | 67 |   | 54 |   |
|                                                     |   |                        |       |                        |       |   |   |   |   |
| Total recoveries of loans previously charged off         |   | 133                         |       | 16                          |       | 327 |   | 352 |   |
| Net charge-offs                                          |   | (126                        | )          | 2,143                       |       | 2,523 |   | 3,611 |   |
| Provision for credit losses                              |   | 10                          |       | 1,525                       |       | 1,265 |   | 1,825 |   |
|                                                     |   |                        |       |                        |       |   |   |   |   |
| Balance, end of period                                   |   | $                           | 3,588      |                        | $          | 4,756 |   | $ | 3,588 |   | $ | 4,756 |   |

 

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

 

9

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NOTE 5—GOODWILL AND OTHER INTANGIBLE ASSETS

 

As of September 30, 2003and December 31, 2002, the Company had goodwill of $2.2 million, and net coredeposit intangibles of $1.9 million and $2.1 million, respectively, from itsacquisition of the South Bay Bank in December 2001.  The gross carrying amount of core deposit intangibles was $2.3million at September 30, 2003 and December 31, 2002, and accumulatedamortization was $397,000 and $223,000, respectively, at such dates.  The core deposit intangibles are estimatedto have a life of 10 years and 4 months. Amortization for intangibles for 2003and each of the next four years is estimated to be $223,000 per year.  In accordance with SFAS No. 142 goodwill isnot amortized.  The Company has no otherindefinite-lived intangible assets.

 

NOTE 6—INCOME TAXES

 

Income tax provision of$242,000 and benefit of $340,000 were recorded for the three months endedSeptember 30, 2003 and 2002, respectively. Income tax provision of $26,000 and benefit of $202,000 were recordedfor the nine months ended September 30, 2003 and 2002, respectively. Thedifference between the statutory tax rate and the effective tax rate for thethree and nine months ended September 30, 2003 is due to the amortization ofthe core deposit intangible not being deductible for tax purposes.

 

At September 30, 2003,the Company had: (i) federal net operating loss carry forwards (“NOLS”) ofapproximately $17.4 million, which begin to expire in the year 2009; (ii)California NOLS of $559,000 which will expire in 2005; (iii) a federalalternative minimum tax “AMT” credit of $298,000; and (iv) a California AMT of$16,000.  The California NOLS were scheduledto expire in 2002; the state legislature suspended NOLS utilization andextended the related carryforward expiration. The AMT credits carry forward indefinitely.

 

NOTE 7—BENEFICIAL CONVERSION RIGHTS OF SUBSIDIARY PREFERRED STOCK

 

In connection with itsacquisition of South Bay Bank, the Company recorded $1.8 million additionalpaid in capital, with a corresponding discount to the minority interest in theSouth Bay Series A Preferred stock, which remained outstanding following theacquisition, related to the beneficial conversion rights of such preferredstock.  The discount was being amortizedagainst retained earnings over the period from the acquisition date through theearliest possible conversion date of the preferred stock (June 30, 2005) usingthe effective yield method.  For the threemonths and nine months ended September 30, 2002 the amount of the discountamortized against retained earnings was $80,000 and $231,000, respectively. Theamortization of the

 

10

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discount was netted against net income to determine income available tocommon shareholders for earnings per share in the 2002 period.  The South Bay Series A Preferred stock wasfully redeemed in December 2002.

 

NOTE 8—COMPREHENSIVE INCOME

 

Comprehensive income iscomprised of net income and all changes to shareholders’ equity, except thosechanges resulting from investments by shareholders and distributions toshareholders.  Total comprehensiveincome is as follows

 
|                                                                          |   | **For  the three months ended  September 30,** |   | **For  the nine months ended  September 30,** |   |
|-------------------------------------------------------------------------------|--------|------------------------------------------------|--------|-----------------------------------------------|--------|
|                                                                          |   | **2003**                                       |   | **2002**                                      |   | **2003** |   | **2002** |   |
| Net income (loss)                                                             |   | $                                              | 292    |                                          | $      | (542 | ) | $ | (130 | ) | $ | (429 | ) |
|                                                                          |   |                                           |   |                                          |   |   |   |   |   |
| Other comprehensive income, before tax, and  unrealized losses on securities: |   |                                           |   |                                          |   |   |   |   |   |
| Unrealized gain (loss) on securities available for  sale                      |   | (62                                            | )      | 62                                            |   | (282 | ) | 354 |   |
| Other comprehensive income (loss), before tax                                 |   | (62                                            | )      | 62                                            |   | (282 | ) | 354 |   |
|                                                                          |   |                                           |   |                                          |   |   |   |   |   |
| Income tax benefit (expense) related to items of  other comprehensive income  |   | 26                                             |   | (25                                           | )      | 117 |   | (145 | ) |
| Other comprehensive loss                                                      |   | (36                                            | )      | 37                                            |   | (165 | ) | 209 |   |
| Total comprehensive income                                                    |   | $                                              | 256    |                                          | $      | (505 | ) | $ | (295 | ) | $ | (220 | ) |

 

NOTE 9—JUNIOR SUBORDINATED DEFERRABLE INTEREST DEBENTURES

 

In 2001, the Company,through National Mercantile Capital Trust I (the “Trust”), issued 15,000 of10.25% fixed-rate preferred securities due July 25, 2031 (the “Trust PreferredSecurities”), with a liquidation amount of $1,000 per Trust Preferred Securityand an aggregate liquidation amount of $15.0 million.  The Trust PreferredSecurities represent undivided beneficial interests in the assets of the Trustand are unconditionally guaranteed by the Company with respect to distributionsand payments upon liquidation, redemption and otherwise pursuant to the termsof a guarantee agreement.

 

The primary assets ofthe Trust are $15.5 million aggregate principal amount of the Company’s 10.25%fixed-rate junior subordinated deferrable interest debentures due July 25,2031, (the “Junior Subordinated Debentures”) that pay interest each January 25and July 25.  The interest isdeferrable, at the Company’s option, for a period up to ten consecutivesemi-annual

 

11

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payments, but in any event not beyond June 25, 2031.  The debentures are redeemable, in whole orin part, at the Company’s option on or after five years from issuance atdeclining premiums to maturity.

 

The Company adopted FASBInterpretation No. 46, Consolidation of Variable Interest Entities (FIN 46) asof July 1, 2003 resulting in the deconsolidation of the Trust. Accordingly, theJunior Subordinated Debentures have been classified in liabilities at September30, 2003 and the related interest was classified as interest expense for thethree months then ended.  For periodsprior to the adoption of FIN 46, the Trust Preferred Securities, net of theissuance cost, were recorded as a minority interest and the related interestwas recorded as a minority interest in the Company’s income.

 

NOTE 10—DERIVATIVE FINANCIAL INSTRUMENTS

 

In January 2003, theCompany entered into a interest rate swap agreement pursuant to which itexchanged a fixed rate payment obligation of 10.25% on a notional principalamount of $15.0 million for a floating rate interest based on the six-monthLondon InterBank Offered Rate plus 458 basis points for a 29-year period endingJuly 25, 2031.  The interest rate swapagreement results in the Company paying or receiving the difference between thefixed and floating rates at specified intervals calculated based on thenotional amounts.  The differential paidor received on the interest rate swap is recognized as an adjustment tointerest expense.  At July 25, 2003, themost recent rate reset date, the Company was paying an interest rate of 5.70%under the terms of the swap which will reduce its interest expense $642,000 forthe twelve months ended December 31, 2003. The counter party to the swap has the option to call the swap under adeclining premium schedule beginning July 2006.

 

The interest rate swapreduces the adverse impact of the 10.25% fixed-rate Junior SubordinatedDebentures in a declining interest rate environment.  The Company does not utilize derivatives for speculativepurposes.  Under Statement of FinancialAccounting Standards No. 133 this swap transaction is designated as a fairvalue hedge.  Accordingly, theineffective portion of the change in the fair value of the swap transaction isrecorded each period in current income. The terms of the swap are symmetrical with the terms of the JuniorSubordinated Debentures, including the payment deferral terms, and consideredhighly effective in offsetting changes in fair value of the Junior SubordinatedDebentures.  Accordingly, a $545,000decrease in the fair value of the swap was recorded in income for the three-monthperiod ended September 30, 2003 and an $88,000 decrease in the fair value ofthe swap was recorded in income for the nine-month period ended September 30,2003 with an offsetting charge to earnings to reflect a similar decrease in thefair value of the Junior Subordinated Debentures.No ineffectiveness wasrecorded to current earnings related to the interest rate swap.

 

The terms of the swaprequire the Company to provide collateral of $1.0 million plus the value of theswap contract in minimum increments of $250,000 when the value is positive forthe counterparty.

 

12

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NOTE 11— CONVERSION OF PREFERRED STOCK

 

In the nine months endedSeptember 30, 2003, 2,200 shares of Series A non-cumulative convertibleperpetual  preferred stock were convertedto 4,400 shares of common stock.

 

NOTE 12—RECLASSIFICATIONS

 

Certain prior year datahave been reclassified to conform to current year presentation.

 

NOTE 13—ACCOUNTING PRONOUNCEMENTS

 

In January 2003, theFASB issued FIN 46.  FIN 46 changes theconsolidation requirements by requiring a variable interest entity to beconsolidated by a company if that company is subject to the majority of therisk of loss from the variable interest entity’s activities or entitled toreceive a majority of the entity’s residual returns or both.  In addition, FIN No. 46 requires disclosuresabout variable interest entities that a company is not required to consolidatebut in which it has a significant variable interest.The consolidationrequirements of FIN No. 46 apply to variable interest entities created afterJanuary 31, 2003 and apply to existing variable interest entities no later thanthe first fiscal year or interim period beginning after June 15, 2003.

 

The Company adopted FIN46 effective July 1, 2003 and accordingly reclassified the Junior SubordinatedDebentures as other liabilities and the related interest as other interestexpense.

 

In May 2003, the FASBissued Statement of Financial Accounting Standards No. 150, Accounting forCertain Financial Instruments with Characteristics of both Liabilities andEquity (SFAS 150).  SFAS 150 establishesstandards for how an issuer classifies and measures certain financialinstruments with characteristics of both liabilities and equity.  It requires than an issuer classify afinancial instrument that is within its scope as a liability (or an asset insome circumstances).  Many of thoseinstruments were previously classified as equity.

 

The Company adopted SFAS150 effective July 1, 2003, which had no effect on the Company’s financialstatements.

 

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***Item 2.******        ******MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION 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.

 

In July 2001, NationalMercantile formed National Mercantile Capital Trust (the “Trust”) as a Delawarestatutory business trust formed for the exclusive purpose of issuing andselling trust preferred securities (the “Trust Preferred Securities”).  The trust issued those securities andutilized the proceeds to purchase from the National Mercantile juniorsubordinated deferrable interest debentures (the “Junior SubordinatedDebentures”).  Through June 30, 2003,the Company’s financial statements reflected the Trust as a consolidatedsubsidiary, with the effect that the Trust Preferred Securities of the Trustwere reflected on the balance sheet as mezzanine equity and payments on theTrust Preferred Securities were set forth as expenses classified as minorityinterest in the Company’s income of the guaranteed preferred beneficialinterest in the Junior Subordinated Debentures.

 

The Company implemented FIN 46 effective July 1, 2003 with the effectthat since that date the Trust has not been a consolidated subsidiary of theCompany for financial reporting purposes. As a result: (i) the Company’s balance sheets as of dates on or afterJuly 1, 2003 no longer reflect the Trust Preferred Securities as mezzanine  equity but instead reflect the JuniorSubordinated Debentures as liabilities, and (ii) the Company’s statements ofoperations incorporating periods on or after July 1, 2003, reflect from July 1,2003 forward interest payments on the Junior Subordinated Debentures asinterest expense and do not reflect payments on the Trust Preferred Securitiesas expenses classified as minority interest in the Company’s income of the guaranteed preferred beneficial interestin the Company’s junior subordinated interest. As discusses below, this has a significant effect on comparisons of netinterest income between periods including and not including periods on andafter July 1, 2003.

 

**RESULTS OF OPERATIONS**

** **

The Company recorded netincome of $292,000, or $0.11 basic earnings per share and $0.07 diluted earningper share, for the three months ended September 30, 2003 compared to a net lossof $542,000, or $0.38 basic and diluted loss per share, for the same period of2002.The increase in net income for the 2003 period was primarily due to a $1.5million decrease in provision for credit losses.  This was partially offset by a $262,000 increase in total otheroperating expenses and a $582,000

 

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increase in income tax provisions. Net interest income before provision for credit losses for the threemonths ended September 30, 2003 reflects a $314,000 decline from the sameperiod in 2002.

 

The Company recorded aloss for the nine months ended September 30, 2003 of  $130,000, or $0.05 basic and diluted loss per share, compared toa net loss of $660,000 for the same period of 2002.  On a per share basis, the results for the nine months endedSeptember 30, 2002 was $0.40 basic and diluted loss per share.  The decrease in net loss was primarily dueto a $560,000 decrease in the provision for credit losses, a $159,000 decreasein the minority interest in the Company’s income of the preferred stock ofSouth Bay and a $100,000 net gain on sale of securitiesavailable-for-sale.  This was partiallyoffset by a $400,000 increase in other operating expenses and a $228,000increase in the provision for income taxes.Net interest income for the ninemonths ended September 30, 2003 was $10.6 million compared to $11.2 million in2002.

 

Return on average assetsduring the third quarter and first nine months of 2003 was 0.31% and a minus0.05%, respectively, compared to minus 0.60% and a minus 0.16% during the thirdquarter and first nine months of 2002, respectively. Return on average equityduring the third quarter and first nine months of 2003 was 3.72% and a minus0.55%, respectively, compared to a minus 8.46% and a minus 2.25% during thethird quarter and first nine months of 2002, respectively.

 

NET INTEREST INCOME

 

Net interest incomebefore the provision for credit losses decreased $314,000 from the thirdquarter of 2002 to the third quarter of 2003 due primarily to the inclusion of$228,000 of expense on the Junior Subordinated Debentures (which comparableexpense was not classified as interest expense in prior periods).  This decrease was also due to the decreasein net interest margin (net yield on earning assets) from 3.98% for the thirdquarter of 2002 to 3.59% in the third quarter of 2003.  This 60 basis point decrease in net interestmargin was due primarily to: (i) lower yielding assets comprising a higherportion of the interest-earning asset portfolio, as the Company invested fundsfrom new deposits and other sources in federal funds and repurchase agreementspending deployment into loans or securities; and (ii) a 196 basis pointdecrease in the weighted average yield on securities available-for-sale due tosignificantly lower yields on newly acquired securities.  The decrease in net interest income occurrednotwithstanding an increase in net interest earning assets (interest earningassets less interest bearing liabilities) from $108.7 million in the thirdquarter of 2002 to $115.1 million in the third quarter of 2003, which occurreddespite the inclusion of $15.4 million of Junior Subordinated Debentures asinterest-bearing liabilities in the 2003 quarter.  This was due primarily to a $22.1 million increase in averagenon-interest bearing demand deposits reflecting the impact of the Company’scontinued emphasis on business banking and the generation of lower cost transactionaldeposits particularly at South Bay, which historically had emphasized timecertificates of deposit.

 

15

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Net interest incomebefore provision for credit losses decreased $570,000 from the nine monthsended September 30, 2003 to the nine months ended September 30, 2003.  Factors effecting this decline were theinclusion of $228,000 of expense on the Junior Subordinated Debentures in the2003 nine months (which comparable expense was not classified as interestexpense in the 2002 nine month) and a decrease in the net interest spread from3.92% to 3.79%.  The decrease in netinterest income occurred notwithstanding an increase in net interest earningassets from $106.1 million in the 2002 nine months to $120.3 million in the2003 nine months, which occurred despite the inclusion of average balance of$5.2 million of Junior Subordinated Debentures as interest-bearing liabilitiesin the 2003 nine months.  This was dueprimarily to a $3.5 million increase in average interest earning assets and a$10.7 million reduction in interest bearing liabilities, as the Companycontinued to replace higher cost time certificates of deposit (the averagebalances of which were reduced by $21.4 million) with non-interest bearingdemand deposits.

 

The weighted averageyields earned on interest earning assets and rates paid on interest bearingliabilities generally declined from the 2002 periods to the 2003 periods as aresult of decreases in market interest rates as a result of the FederalReserve’s reduction in the federal funds rate in response to the slow economy.

 

The net yield on earningassets was 4.11% for the three months ended September 30, 2003 compared to4.71% for the same period in 2002 due to a change in mix of interest earningassets to lower yielding asset types and the overall decline in yields.  Partially mitigating the decline in netyield on earning assets was an overall decline in deposit rates, a change indeposit mix to lower costing deposits, and an increase in noninterest-bearingdemand deposits.

 

The net yield oninterest-earning assets decreased from 4.67% to 4.38% due to an overall declinein yields on interest earning assets, partially offset by overall declines indeposit rates, a change in deposit mix to lower costing deposits, and anincrease in noninterest bearing demand deposits.

 

Average loans receivabledecreased $3.8 million or 1.4% for the three months ended September 30, 2003compared to the same period in 2002 primarily due to the repayment ofconstruction loans in the 2003 period. Due to the nature of construction loans, the outstanding balance ofnewly originated loans increases gradually during the life of the loan andrepays in a lump sum.  The weightedaverage yield on loans receivable declined 60 basis points to 6.03% for thethird quarter 2003.  The lower yields onloans receivable are due to the sustained decline in interest rates over thepast two years affecting the yields on adjustable rate loans tied to rateindices as well as the yields on newly originated fixed rate loans and existingfixed rate loans upon renewal at maturity.

 

16

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Securitiesavailable-for-sale and securities held-to-maturity increased slightly to $30.7million average for the three months ended September 30, 2003 compared to $30.6million average for the period ended September 30, 2002.The weighted averageyield on securities available-for-sale was 3.26% and 5.20% for the three monthsended September 30, 2003 and 2002, respectively, representing a 194 basis pointdecline.  The decline in yield was dueto purchases of securities in the declining rate environment during 2002 and toa lesser extent, adjustable rate securities in the portfolio.  The weighted average yield on securitiesheld-for-maturity was 3.34% for the three months ended September 30, 2003.  There were no securities held-for-maturityduring the three months ended September 30, 2002.  Federal funds sold averaged $43.2 million and yielded 0.84%during the third quarter of 2003 compared to an average of $24.5 millionyielding 1.70% for the same period in 2002.

 

Average loans receivableincreased $5.1 million for the nine months ended September 30, 2003 compared tothe same period in 2002.  The weightedaverage yield on loans receivable declined 65 basis points to 6.13% for thenine months ended September 30, 2003. The lower yields on loans receivable are due to the sustained decline ininterest rates over the past two years affecting the yields on adjustable rateloans tied to rate indices as well as the yields on newly originated fixed rateloans and existing fixed rate loans upon renewal at maturity.  Securities available for sale decreased $7.1million or 21.9% for the nine months ended September 30, 2003 compared to thesame period in 2002, in order to fund higher yielding loans, reduce higher costfunding sources and to reduce the exposure to a decline in market value in theevent that market rates begin to rise. The weighted average yield on securities available for sale was 3.37%and 5.50% for the nine months ended September 30, 2003 and 2002, respectively,representing a 213 basis point decline for the nine months ended September 30,2003.  The decline in yield was due topurchases of securities in the declining rate environment during 2002 and to alesser extent, adjustable rate securities in the portfolio. The weightedaverage yield on securities held-for-maturity was 3.30% for the nine monthsended September 30, 2003.Federal funds sold averaged $33.0 million and yielded1.09% during the nine months ended September 30, 2003 compared to an average of$28.6 million yielding 1.69% for the same period in 2002.

 

Average total depositsincreased $16.4 million or 5.4% to $317.6 million during the third quarter of2003 compared to $301.2 million during the third quarter of 2002.  Federal funds purchased and securities soldunder agreements to repurchase averaged $606,000 and $1.8 million for the threemonths ended September 30, 2003 and 2002, respectively.  Average total other borrowings decreasedslightly from $7.6 million the quarter ended September 30, 2002, to $7.5million during the quarter ended September 30, 2003.  Other borrowings included advances from the Federal Home LoanBank.  Junior subordinated debentureswere reclassified as interest-bearing liabilities upon adoption of SFAS 150 andFIN 46 as previously discussed.  Theaverage was $15.5 million for the three months September 30, 2003.

 

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Average total depositsincreased $8.9 million or 3.0% to $307.9 million during the nine months endedSeptember 30, 2003 compared to $299.0 million during the nine months endedSeptember 30, 2002.  Federal fundspurchased and securities sold under agreements to repurchase averaged $686,000and $2.6 million for the nine months ended September 30, 2003 and 2002,respectively.  Average total otherborrowings decreased $5.1 million or 40.4% to $7.5 million during the ninemonths ended September 30, 2003 compared to $12.6 million during the ninemonths ended September 30, 2002 reflecting a planned reduction in theserelatively high cost funds provided for by a reduction in securities availablefor sale.  Junior subordinated debentureswere reclassified as interest-bearing liabilities upon adoption of SFAS 150 andFIN 46 as previously discussed.  Theaverage was $5.2 million for the nine months September 30, 2003.  This was not reported as an interest-bearingliability for the period ending September 30, 2002.

 

The weighted averagecost of interest bearing liabilities declined 62 basis points to 1.51% duringthe third quarter of 2003 from 2.13% the during the third quarter of 2002.  This change was a result of a decrease inthe weighted average cost of interest bearing deposits to 1.04% during thethird quarter of 2003 compared to 2.01% during the third quarter of 2002.  The decline in the weighted average cost ofdeposits was due to a lower volume of higher-costing time certificates ofdeposit as well as lower rates on deposits. The change in the composition of deposits reflects management’s emphasison business banking at South Bay, which resulted in lower cost transactiondeposit accounts.

 

The weighted averagecost of interest bearing liabilities declined 66 basis points to 1.60% duringthe nine months ended September 30, 2003 from 2.26% the during the nine monthsended September 30, 2002.  This changewas a result of a decrease in the weighted average cost of interest bearing depositsto 1.36% during the nine months ended September 30, 2003 compared to 2.10%during the nine months ended September 30, 2002.  The decline in the weighted average cost of deposits was due to alower volume of higher-costing time certificates of deposit as well as lowerrates on deposits.  The change in thecomposition of deposits reflects management’s emphasis on business banking atSouth Bay, which resulted in lower cost transaction deposit accounts.

 

The weighted averagecost of other borrowings was 4.71% during the third quarter of 2003 compared to4.78% during the third quarter of 2002.

 

The weighted averagecost of other borrowings was 4.76% during the nine months ended September 30,2003 compared to 4.12% during the nine months ended September 30, 2002.  The increase was due to the maturity oflower costing borrowings.

 

Averagenoninterest-bearing demand deposits increased $22.1 million or 21.5% during thethird quarter 2003 to $125.4 million from $103.2 million due to management’semphasis on growth in business banking.

 

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Averagenoninterest-bearing demand deposits increased $17.7 million or 17.7% during thenine months ended September 30, 2003 to $117.8 million from $100.1 million dueto an increase in business transaction accounts.

 

The following tablepresents the components of net interest income for the three months endedSeptember 30, 2003 and 2002.

 

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**Average Balance Sheet and**

**Analysis of Net Interest Income**

 
|                                                                                                                     |   | **Three  months ended**    |    |
|--------------------------------------------------------------------------------------------------------------------------|--------|----------------------------|---------|
|                                                                                                                     |   | **September  30, 2003**    |    | **September  30, 2002** |   |
|                                                                                                                     |   | **Average  Amount**        |    | **Weighted  Interest  Income/  Expense** |   | **Average  Yield/  Rate** |   | **Average  Amount** |   | **Interest  Income/  Expense** |   | **Weighted****Average****Yield/  Rate** |   |
|                                                                                                                     |   | **(Dollars in thousands)** |    |
| Assets:                                                                                                                  |   |                       |    |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Federal funds sold and securities purchased under  agreements to resell                                                  |   | $                          | 43,228  |   | 92 |   | 0.84 | % | $ | 24,454 |   | $ | 105 |   | 1.70 | % |
| Interest-bearing deposits with other financial  institutions                                                             |   | 363                        |    | 5 |   | 5.39 | % | — |   | — |   | — |   |
| Securities available-for-sale                                                                                            |   | 28,341                     |    | 231 |   | 3.26 | % | 30,621 |   | 401 |   | 5.20 | % |
| Securities held-to-maturity                                                                                              |   | 2,395                      |    | 20 |   | 3.34 | % | — |   | — |   | — |   |
| Loans receivable (1) (2)                                                                                                 |   | 257,328                    |    | 3,914 |   | 6.03 | % | 261,109 |   | 4,363 |   | 6.63 | % |
| Total interest earning assets                                                                                            |   | 331,655                    |    | 4,262 |   | 5.10 | % | 316,184 |   | 4,869 |   | 6.11 | % |
|                                                                                                                     |   |                       |    |   |   |   |   |   |   |   |   |   |   |
| Noninterest earning assets:                                                                                              |   |                       |    |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks - demand                                                                                         |   | 22,764                     |    |   |   |   |   | 20,051 |   |   |   |   |   |
| Other assets                                                                                                             |   | 22,032                     |    |   |   |   |   | 23,827 |   |   |   |   |   |
| Allowance for credit losses and net unrealized gain  on sales of securities available-for-sale                           |   | (3,480                     | )       |   |   |   |   | (5,927 | ) |   |   |   |   |
| Total assets                                                                                                             |   | $                          | 372,971 |   |   |   |   |   | $ | 354,135 |   |   |   |   |   |
|                                                                                                                     |   |                       |    |   |   |   |   |   |   |   |   |   |   |
| Liabilities and shareholders’ equity:                                                                               |   |                       |    |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing deposits:                                                                                               |   |                       |    |   |   |   |   |   |   |   |   |   |   |
| Demand                                                                                                                   |   | $                          | 29,781  |   | 21 |   | 0.28 | % | $ | 27,970 |   | $ | 86 |   | 1.22 | % |
| Money market and savings                                                                                                 |   | 102,838                    |    | 181 |   | 0.70 | % | 91,443 |   | 388 |   | 1.68 | % |
| Time certificates of deposit:                                                                                            |   |                       |    |   |   |   |   |   |   |   |   |   |   |
| $100,000 or more                                                                                                         |   | 27,504                     |    | 163 |   | 2.35 | % | 41,801 |   | 172 |   | 1.63 | % |
| Under $100,000                                                                                                           |   | 32,158                     |    | 138 |   | 1.70 | % | 36,808 |   | 357 |   | 3.85 | % |
| Total time certificates of deposit                                                                                       |   | 59,662                     |    | 301 |   | 2.00 | % | 78,609 |   | 529 |   | 2.67 | % |
| Total interest-bearing deposits                                                                                          |   | 192,281                    |    | 503 |   | 1.04 | % | 198,022 |   | 1,003 |   | 2.01 | % |
| Other borrowings                                                                                                         |   | 7,500                      |    | 89 |   | 4.71 | % | 7,638 |   | 92 |   | 4.78 | % |
| Junior subordinated debentures                                                                                           |   | 15,464                     |    | 228 |   | 5.85 | % | — |   | — |   | — |   |
| Federal funds purchased and securities sold under  agreements to repurchase                                              |   | 606                        |    | 3 |   | 1.96 | % | 1,782 |   | 21 |   | 4.68 | % |
| Total interest-bearing liabilities                                                                                       |   | 215,851                    |    | 823 |   | 1.51 | % | 207,442 |   | 1,116 |   | 2.13 | % |
|                                                                                                                     |   |                       |    |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing liabilities:                                                                                         |   |                       |    |   |   |   |   |   |   |   |   |   |   |
| Noninterest bearing demand deposits                                                                                      |   | 125,363                    |    |   |   |   |   | 103,220 |   |   |   |   |   |
| Other liabilities                                                                                                        |   | 620                        |    |   |   |   |   | 2,994 |   |   |   |   |   |
| Guaranteed preferred beneficial interests in the  Company’s junior subordinated deferrable interest debentures, net |   | —                     |    |   |   |   |   | 14,524 |   |   |   |   |   |
| Minority interest of the preferred stock of  subsidiary                                                                  |   | —                     |    |   |   |   |   | 869 |   |   |   |   |   |
| Shareholders’ equity                                                                                                |   | 31,137                     |    |   |   |   |   | 25,086 |   |   |   |   |   |
| Total liabilities and shareholders’ equity                                                                          |   | $                          | 372,971 |   |   |   |   |   | $ | 354,135 |   |   |   |   |   |
|                                                                                                                     |   |                       |    |   |   |   |   |   |   |   |   |   |   |
| Net interest income (spread)                                                                                             |   |                       |    | $ | 3,439 |   | 3.59 | % |   |   | $ | 3,753 |   | 3.98 | % |
|                                                                                                                     |   |                       |    |   |   |   |   |   |   |   |   |   |   |
| Net yield on earning assets (2)                                                                                          |   |                       |    |   |   | 4.11 | % |   |   |   |   | 4.71 | % |
|                                                                                                                          |        |                            |         |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

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

(2) Yields and amounts earned on loansreceivable include loan fees of $239,000 and $116,000 for the three monthsended September 30, 2003 and 2002, respectively. 

 

20

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The following tablepresents the components of net interest income for the nine months endedSeptember 30, 2003 and 2002.

 

21

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|                                                                                                                     |   | **Nine  months ended**      |    |
|--------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|---------|
|                                                                                                                     |   | **September  30, 2003**     |    | **September  30, 2002** |   |
|                                                                                                                     |   | **Average  Amount**         |    | **Interest  Income/  Expense** |   | **Weighted  Average  Yield/  Rate** |   | **Average  Amount** |   | **Interest  Income/  Expense** |   | **Weighted  Yield/  Rate** |   |
|                                                                                                                     |   | **(Dollars  in thousands)** |    |
| Assets:                                                                                                                  |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Federal funds sold and securities purchased under  agreements to resell                                                  |   | $                           | 32,974  |   | 268 |   | 1.09 | % | $ | 28,588 |   | $ | 361 |   | 1.69 | % |
| Interest-bearing deposits with other financial  institutions                                                             |   | 338                         |    | 5 |   | 1.95 | % | — |   | — |   | — |   |
| Securities available-for-sale                                                                                            |   | 25,296                      |    | 640 |   | 3.37 | % | 32,383 |   | 1,331 |   | 5.50 | % |
| Securities held-to-maturity                                                                                              |   | 807                         |    | 20 |   | 3.30 | % | — |   | — |   | — |   |
| Loans receivable (1) (2)                                                                                                 |   | 264,345                     |    | 12,121 |   | 6.13 | % | 259,211 |   | 13,115 |   | 6.78 | % |
| Total interest earning assets                                                                                            |   | 323,760                     |    | 13,054 |   | 5.39 | % | 320,182 |   | 14,807 |   | 6.18 | % |
|                                                                                                                     |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Noninterest earning assets:                                                                                              |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks - demand                                                                                         |   | 21,884                      |    |   |   |   |   | 20,251 |   |   |   |   |   |
| Other assets                                                                                                             |   | 21,574                      |    |   |   |   |   | 24,035 |   |   |   |   |   |
| Allowance for credit losses and net unrealized gain  on sales of securities available-for-sale                           |   | (4,161                      | )       |   |   |   |   | (5,925 | ) |   |   |   |   |
| Total assets                                                                                                             |   | $                           | 363,057 |   |   |   |   |   | $ | 358,543 |   |   |   |   |   |
|                                                                                                                     |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Liabilities and shareholders’ equity:                                                                               |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing deposits:                                                                                               |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Demand                                                                                                                   |   | $                           | 28,349  |   | 110 |   | 0.52 | % | $ | 27,762 |   | $ | 243 |   | 1.17 | % |
| Money market and savings                                                                                                 |   | 97,077                      |    | 736 |   | 1.01 | % | 85,037 |   | 1,087 |   | 1.71 | % |
| Time certificates of deposit:                                                                                            |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| $ 100,000 or more                                                                                                        |   | 30,172                      |    | 429 |   | 1.90 | % | 46,545 |   | 673 |   | 1.93 | % |
| Under $100,000                                                                                                           |   | 34,526                      |    | 657 |   | 2.54 | % | 39,586 |   | 1,117 |   | 3.77 | % |
| Total time certificates of deposit                                                                                       |   | 64,698                      |    | 1,086 |   | 2.24 | % | 86,131 |   | 1,790 |   | 2.78 | % |
| Total interest-bearing deposits                                                                                          |   | 190,124                     |    | 1,932 |   | 1.36 | % | 198,930 |   | 3,120 |   | 2.10 | % |
| Other borrowings                                                                                                         |   | 7,500                       |    | 267 |   | 4.76 | % | 12,592 |   | 388 |   | 4.12 | % |
| Junior subordinated debentures                                                                                           |   | 5,155                       |    | 228 |   | 5.91 | % | — |   | — |   | — |   |
| Federal funds purchased and securities sold under  agreements to repurchase                                              |   | 686                         |    | 14 |   | 2.73 | % | 2,562 |   | 116 |   | 6.05 | % |
| Total interest-bearing liabilities                                                                                       |   | 203,465                     |    | 2,441 |   | 1.60 | % | 214,084 |   | 3,624 |   | 2.26 | % |
|                                                                                                                     |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing liabilities:                                                                                         |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Noninterest bearing demand deposits                                                                                      |   | 117,791                     |    |   |   |   |   | 100,078 |   |   |   |   |   |
| Other liabilities                                                                                                        |   | 743                         |    |   |   |   |   | 3,666 |   |   |   |   |   |
| Guaranteed preferred beneficial interests in the  Company’s junior subordinated deferrable interest debentures, net |   | 9,689                       |    |   |   |   |   | 14,520 |   |   |   |   |   |
| Minority interest of the preferred stock of  subsidiary                                                                  |   | —                      |    |   |   |   |   | 791 |   |   |   |   |   |
| Shareholders’ equity                                                                                                |   | 31,369                      |    |   |   |   |   | 25,404 |   |   |   |   |   |
| Total liabilities and shareholders’ equity                                                                          |   | $                           | 363,057 |   |   |   |   |   | $ | 358,543 |   |   |   |   |   |
|                                                                                                                     |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Net interest income (spread)                                                                                             |   |                        |    | $ | 10,613 |   | 3.79 | % |   |   | $ | 11,183 |   | 3.92 | % |
|                                                                                                                     |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Net yield on earning assets (2)                                                                                          |   |                        |    |   |   | 4.38 | % |   |   |   |   | 4.67 | % |
|                                                                                                                          |        |                             |         |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1) The average balance of nonperforming loans has been included inloans receivable.

(2) Yields and amounts earned on loans receivable include loan fees of$656,000 and $395,000 for the nine months ended September 30, 2003 and 2002,respectively.

 

22

----

 

 

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

 

**Increase (Decrease) in Interest Income/Expense Due toChange in**

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

 
|                                                                        |       | **Nine  months ended September 30,  2003 vs 2002** | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------------------------------------|------------|
|                                                                        |       |                                               | ** ** | **Net  Increase****(Decrease)** |   |
| **Increase  (decrease) due to:**                                            |
| **Volume**                                                                  | ** ** | **Rate**                                           |
|                                                                        |       |                                               |       |   |   |   |   |
| Interest Income:                                                            |       |                                               |       |   |   |   |   |
| Federal funds sold and securities purchased under  agreement to resell      |       | $                                                  | 55         |   | $ | (148 | ) | $ | (93 | ) |
| Interest-bearing deposits with other financial  institutions                |       | 5                                                  |       | — |   | 5 |   |
| Securities available-for-sale                                               |       | (293                                               | )          | (398 | ) | (691 | ) |
| Securities held-to-maturity                                                 |       | 20                                                 |       | — |   | 20 |   |
| Loans receivable (2)                                                        |       | 260                                                |       | (1,254 | ) | (994 | ) |
|                                                                        |       |                                               |       |   |   |   |   |
| Total interest-earning assets                                               |       | 47                                                 |       | (1,800 | ) | (1,753 | ) |
|                                                                        |       |                                               |       |   |   |   |   |
| Interest Expense:                                                           |       |                                               |       |   |   |   |   |
| Interest-bearing deposits:                                                  |       |                                               |       |   |   |   |   |
| Demand                                                                      |       | $                                                  | 5          |   | $ | (138 | ) | $ | (133 | ) |
| Money market and savings                                                    |       | 154                                                |       | (505 | ) | (351 | ) |
| Time certificates of deposit:                                               |       |                                               |       |   |   |   |   |
| $100,000 or more                                                            |       | (237                                               | )          | (7 | ) | (244 | ) |
| Under $100,000                                                              |       | (143                                               | )          | (317 | ) | (460 | ) |
|                                                                        |       |                                               |       |   |   |   |   |
| Total time certificates of deposit                                          |       | (380                                               | )          | (324 | ) | (704 | ) |
| Total interest-bearing deposits                                             |       | (221                                               | )          | (967 | ) | (1,188 | ) |
| Other borrowings                                                            |       | (157                                               | )          | 36 |   | (121 | ) |
| Junior subordinated debentures                                              |       | 228                                                |       | — |   | 228 |   |
| Federal funds purchased and securities sold under  agreements to repurchase |       | (85                                                | )          | (17 | ) | (102 | ) |
| Total interest-bearing liabilities                                          |       | (235                                               | )          | (948 | ) | (1,183 | ) |
|                                                                        |       |                                               |       |   |   |   |   |
| Net interest income                                                         |       | $                                                  | 282        |   | $ | (852 | ) | $ | (570 | ) |

 

----

(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 the absoluteamounts of changes in each.

(2) Table does not include interest income that would have been earnedon nonaccrual loans.

 

23

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PROVISION FOR CREDITLOSSES

 

Provisions for credit losses were $10,000 and $1.3 million, for thethree months and nine months ended September 30, 2003, respectively, comparedto $1.5 million and $1.8 million for the three months and nine months endedSeptember 30, 2002, respectively.  Thedecrease in provisions for credit losses during the third quarter 2003 was dueto the decrease in loans outstanding for the period and the current adequacy ofthe allowance for credit losses based upon our analysis.  See Note 4 of Notes to ConsolidatedFinancial Statements.

 

OTHER OPERATING INCOME

 

Other operating income increased to $397,000 during the third quarterof 2003 from $353,000 during the third quarter of 2002 primarily due to anincrease in deposit-related and other customer service income.

 

Other operating income increased to $1.1 million during the nine monthsended September 30, 2003 from $1.0 million during the nine months endedSeptember 30, 2002 due to net gains on sales of securities of $100,000 for the2003 period compared to no gains for the 2002 period and an $36,000 increase indeposit-related and other customer service income, offset by a loss on sale ofother real estate owned in 2003 for $61,000.

 

Net gains on sales of securities are generated primarily in declininginterest rate environments.    Accordingly, gains or losses from sales ofsecurities may fluctuate significantly from period to period, and the resultsin any period are not necessarily indicative of the results, which may beobtained in future periods.

 

OTHER OPERATING EXPENSES

 

Other operating expense increased to $3.3million for the three months ended September 30, 2003 compared to $3.0 millionfor the same period in 2002. Variances within operating expenses were reflectedas follows; (i) salaries and related benefits expense increased $62,000, or3.6%; (ii) client services expense decreased $26,000 or 16.8%; (iii) computerdata processing expense increased $37,000 or 16.5%; (iv) legal serivces expenseincreased $50,000, or 69.4%; (v) other professional services expense increased$108,000 or 110.2%;  (vi) amortizationof core deposit intangible expense increased $56,000; and (vii) promotion andother expenses decreased $46,000 or 52.9%.

 

Other operating expense increased by $400,000 to$10.1 million during the nine months ended September 30, 2003 compared to $9.7million during nine months ended September 30, 2002.  This increase was reflected as follows; (i) salaries and relatedbenefits expense increased $327,000, or 6.4%; (ii) net occupancy expense decreased$64,000 or 6.0%; (iii) client

 

24

----

 

services expensedecreased $152,000, or 25.3%;  (iv)legal services expense decreased $70,000, or 15.5%; and (v) amortization ofcore deposits expenses increased $168,000.

 

The increase in salary and related expense inthe third quarter of 2003  is due togreater temporary help expense and an increase in incentive bonus accrual.  The temporary help expense is expected todecrease in later quarters, however, it will be largely offset by salaryexpense.  The decline in client servicesis primarily related to the decrease in services by the escrow customers.Although legal expenses increased in the third quarter of 2003 as compared tothe third quarter of 2002, legal expenses for the nine months ending September30, 2003 are 15.5% lower than the same period of 2002 primarily due to lowerfees relating to credit collection. Other professional expense increased forthe three months ended September 30, 2003 to $206,000 from $98,000 during thethird quarter of 2002.  This increase isdue to a sales training program, and an increase in audit fee and consultingfees.

 

MINORITY INTEREST IN THECOMPANY’S INCOME

 

Theminority interest in the Company’s income of the guaranteed beneficial interestin the Company’s Junior Subordinated Debentures $380,000 for the three monthsended September 30, 2002.  As a resultof the reclassification pursuant to FIN 46 effective July 1, 2003, no suchminority interest expense was recorded for three months ended September 30,2003.  The minority interest in theCompany’s income of the guaranteed beneficial interest in the JuniorSubordinated Debenture was $456,000 and $1,153,000 for the nine months endedSeptember 30, 2003 and 2002, respectively. This reduction reflected, in part, the reclassification.

 

Thisreduction also reflected the effect of an interest rate swap agreement that theCompany entered into in January 2003 in which it exchanged a fixed rate paymentobligation of 10.25% on a notional principal amount of $15.0 million for afloating interest rate based on the six-month London InterBank Offered Rateplus 458 basis points for a 29-year period ending July 25, 2031.  The weighted average cost of the TrustPreferred Securities/Junior Subordinated Debentures was 5.83% and 10.25% forthe nine months ended September 30, 2003 and 2002, respectively.  On July 25, 2003 the interest rate reset to5.70% per annum.

 

Thisswap transaction is designated as a fair value hedge.  Accordingly, a $545,000 decrease in the fair value of the swapwas recorded in income for the three-month period ended September 30,2003.  The terms of the swap aresymmetrical with the terms of the Junior Subordinated Debentures, including thepayment deferral terms, and considered highly effective in offsetting changesin fair value of the Junior Subordinated Debentures.  Accordingly, an offsetting charge to earnings was

 

25

----

 

recorded for the threemonths ended September 30, 2003 to reflect the increase in the fair value ofthe Junior Subordinated Debentures.  SeeNote 10 of Notes to Consolidated Financial Statements.

 

***BALANCE SHEETANALYSIS***

 

INVESTMENT SECURITIES

 

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

 

26

----

 

**Estimated Fair Values of and Unrealized**

**Gains and Losses on Securities**

 
|                                                                      |   | **September  30, 2003**     |       |
|---------------------------------------------------------------------------|--------|-----------------------------|------------|
|                                                                      |   | **Total  amortized  cost**  |       | **Gross  unrealized  gains** | ** ** | **Gross  unrealized  loss** | ** ** | **Estimated  fair  value** | ** ** |
|                                                                      |   | **(Dollars  in thousands)** | ** ** |
| **Available-for-Sale:**                                                   |   |                        |       |   |   |   |   |   |   |
| U.S. Treasury securities                                                  |   | $                           | 3,096      |   | $ | — |   | $ | — |   | $ | 3,096 |   |
| GNMA-issued/guaranteed mortgage pass through  certificates                |   | 454                         |       | 13 |   | — |   | 467 |   |
| Other U.S. Government and federal agency securities                       |   | 7,256                       |       | 46 |   | — |   | 7,302 |   |
| FHLMC/FNMA-issued mortgage pass through  certificates                     |   | 6,315                       |       | 197 |   | — |   | 6,512 |   |
| CMO’s and REMIC’s issued by U.S.  government-sponsored agencies |   | 703                         |       | — |   | 18 |   | 685 |   |
| Mutual funds                                                              |   | 10,000                      |       | — |   | 36 |   | 9,964 |   |
| Privately issued corporate bonds, CMO and REMIC  securities               |   | 3,426                       |       | 7 |   | 145 |   | 3,288 |   |
|                                                                      |   | $                           | 31,250     |   | $ | 263 |   | $ | 199 |   | $ | 31,314 |   |
|                                                                      |   |                        |       |   |   |   |   |   |   |
| FRB and other equity stocks                                               |   | $                           | 1,869      |   | — |   | — |   | $ | 1,869 |   |

 
|                                                                      |   | **September  30, 2003**     | ** ** |
|---------------------------------------------------------------------------|--------|-----------------------------|------------|
|                                                                      |   | **Total  amortized  cost**  |       | **Gross  unrealized  gains** | ** ** | **Gross  unrealized  loss** | ** ** | **Estimated  fair  value** | ** ** |
|                                                                      |   | **(Dollars  in thousands)** | ** ** |
| **Held-to-Maturity:**                                                     |   |                        |       |   |   |   |   |   |   |
| U.S. Treasury securities                                                  |   | $                           | —     |   | $ | — |   | $ | — |   | $ | — |   |
| GNMA-issued/guaranteed mortgage pass through  certificates                |   | —                      |       | — |   | — |   | — |   |
| Other U.S. Government and federal agency securities                       |   | —                      |       | — |   | — |   | — |   |
| FHLMC/FNMA-issued mortgage pass through  certificates                     |   | 4,869                       |       | 23 |   | — |   | 4,892 |   |
| CMO’s and REMIC’s issued by U.S.  government-sponsored agencies |   | —                      |       | — |   | — |   | — |   |
| Mutual funds                                                              |   | —                      |       | — |   | — |   | — |   |
| Privately issued corporate bonds, CMO and REMIC  securities               |   | —                      |       | — |   | — |   | — |   |
|                                                                      |   | $                           | 4,869      |   | $ | 23 |   | $ | — |   | $ | 4,892 |   |

 
|                                                                      |   | **December  31, 2002**       | ** ** |
|---------------------------------------------------------------------------|--------|------------------------------|------------|
|                                                                      |   | **Total****amortized  cost** | ** ** | **Gross****unrealized  gains** | ** ** | **Gross****unrealized  loss** | ** ** | **Estimated****fair  value** | ** ** |
|                                                                      |   | **(Dollars  in thousands)**  | ** ** |
| **Available-for-Sale:**                                                   |   |                         |       |   |   |   |   |   |   |
| U.S. Treasury securities                                                  |   | $                            | 998        |   | $ | — |   | $ | 1 |   | $ | 997 |   |
| GNMA-issued/guaranteed mortgage pass through  certificates                |   | 2,409                        |       | 73 |   | — |   | 2,482 |   |
|                                                                      |   |                         |       |   |   |   |   |   |   |
| FHLMC/FNMA-issued mortgage pass through  certificates                     |   | 12,370                       |       | 506 |   | — |   | 12,876 |   |
| CMO’s and REMIC’s issued by U.S.  government-sponsored agencies |   | 4,544                        |       | 44 |   | — |   | 4,588 |   |
| Privately issued corporate bonds, CMO and REMIC  securities               |   | 5,503                        |       | 12 |   | 288 |   | 5,227 |   |
|                                                                      |   | $                            | 25,824     |   | $ | 635 |   | $ | 289 |   | $ | 26,170 |   |
|                                                                      |   |                         |       |   |   |   |   |   |   |
| FRB and other equity stocks                                               |   | $                            | 2,018      |   | — |   | — |   | $ | 2,018 |   |

 

27

----

 

As of September 30, 2003 the Company did not hold securities of anyissuer, other than U.S. government agencies and corporations, the aggregatebook value of which exceeded 10% of the Company’s shareholders’ equity.  The Company had no securities classified asheld-to-maturity at December 31, 2002.

 

LOANPORTFOLIO

 

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

 

**Loan Portfolio Composition**

 
|                                                                  |   | **September  30,  2003**    | ** ** | **December  31,  2002** | ** ** |
|-----------------------------------------------------------------------|--------|-----------------------------|------------|-------------------------|------------|
|                                                                  |   | **Amount**                  |       | **Percent**             | ** ** | **Amount** | ** ** | **Percent** | ** ** |
|                                                                  |   | **(Dollars  in thousands)** | ** ** |
| Commercial loans:                                                     |   |                        |       |                    |       |   |   |   |   |
| Secured by one to four family residential  properties                 |   | $                           | 6,540      |                    | 3          | % | $ | 10,797 |   | 4 | % |
| Secured by multifamily residential properties                         |   | 10,912                      |       | 4                       | %          | 12,596 |   | 5 | % |
| Secured by commercial real properties                                 |   | 121,364                     |       | 49                      | %          | 119,872 |   | 44 | % |
| Other - secured and unsecured                                         |   | 78,151                      |       | 32                      | %          | 86,015 |   | 32 | % |
| Real estate construction and land development                         |   | 28,506                      |       | 12                      | %          | 37,934 |   | 14 | % |
| Consumer installment, home equity and unsecured  loans to individuals |   | 2,594                       |       | 1                       | %          | 5,566 |   | 1 | % |
| Total loans outstanding                                               |   | 248,067                     |       | 100                     | %          | 272,780 |   | 100 | % |
|                                                                  |   |                        |       |                    |       |   |   |   |   |
| Deferred net loan origination fees and purchased  loan discount       |   | (602                        | )          |                    |       | (457 | ) |   |   |
| Loans receivable, net                                                 |   | $                           | 247,465    |                    |       |   | $ | 272,323 |   |   |   |

 

Total loans outstandingdecreased by $24.7 million to $248.1 million at September 30, 2003 compared to$272.8 million at December 31, 2002 as loan payoffs exceeded loanoriginations.  While all loan categoriesreflects declines except for commercial real estate loans, the payoffs were primarilyin the construction loans.  Due to thenature of construction loans, the outstanding balance of newly originated loanincreases gradually during the life of the loan and repays in a lump sum.

 

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NONPERFORMINGASSETS

 

The following comparative period-end table sets forth certaininformation concerning nonperforming assets.

 

**Nonperforming Assets**

 
|                                                                                                                       |   | **September  30,  2003**    |   | **December  31  2002** |   |
|----------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|--------|------------------------|--------|
|                                                                                                                       |   | **(Dollars  in thousands)** |   |
| Nonaccrual loans                                                                                                           |   | $                           | 442    |                   | $      | 5,787 |   |
| Troubled debt restructurings                                                                                               |   | —                      |   | —                 |   |
| Loans contractually past due ninety or more days  with respect to either principal or interest and still accruing interest |   | 51                          |   | 209                    |   |
| Nonperforming loans                                                                                                        |   | 493                         |   | 5,996                  |   |
| Other real estate owned                                                                                                    |   | 1,000                       |   | 1,000                  |   |
| Other nonperforming assets                                                                                                 |   | —                      |   | —                 |   |
| Total nonperforming assets                                                                                                 |   | $                           | 1,493  |                   | $      | 6,996 |   |
|                                                                                                                       |   |                        |   |                   |   |
| Allowance for credit losses as a percent of  nonaccrual loans                                                              |   | 811.8                       | %      | 83.7                   | %      |
| Allowance for credit losses as a percent of  nonperforming loans                                                           |   | 727.8                       | %      | 80.8                   | %      |
| Total nonperforming assets as a percent of loans  receivable                                                               |   | 0.6                         | %      | 2.6                    | %      |
| Total nonperforming assets as a percent of total  shareholders’ equity                                                |   | 4.8                         | %      | 22.4                   | %      |

 

Nonaccrual loans decreased $5.3 million at September 30, 2003 to$442,000 from $5.8 million at December 31, 2002 due primarily to collection ofnonaccrual loans and loan charge offs. There was $51,000 loans past due 90 daysor more and still accruing interest at September 30, 2003 compared to $209,000at December 31, 2002.  As a result, theamount of nonperforming assets at September 30, 2003 decreased 78.7% to $1.5million from  $7.0 million at December31, 2002.

 

ALLOWANCEFOR CREDIT LOSSES

 

Provisionsfor credit losses charged to operations reflect management’s judgment of theadequacy of the allowance for credit losses and are determined through periodicanalysis of the loan portfolio.  Thisanalysis includes a detailed review of the classification and categorization ofproblem loans and loans to be charged off; an assessment of the overall qualityand collectibility of the portfolio; and consideration of the loan lossexperience, trends in problem loan concentrations of credit risk, as well ascurrent and expected future economic conditions (particularly SouthernCalifornia). Management, in conjunction

 

29

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with an outside advisory firm, performs a periodic risk and creditanalysis, the results of which are reported to the Board of Directors.

 

Loans charged off during the third quarter and first nine months of 2003were $7,000 and $2.9 million, respectively, compared to $2.2 million and $4.0million during the third quarter and first nine months of 2002,respectively.  Recoveries of loanspreviously charged off were $133,000 and $327,000 during the third quarter andfirst nine months of 2003 compared to $16,000 and $352,000 during the thirdquarter and first nine months of 2002, respectively.  See Note 4 of Notes to Consolidated Financial Statements.

 

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.

 

TOTAL DEPOSITS

 

Total deposits were $315.4 million and $298.7 million at September 30,2003 and December 31, 2002, respectively. Noninterest-bearing demand deposits and money market deposits were$127.4 million and $59.8 million, respectively, at September 30, 2003 comparedto $107.6 million and $43.1 million, respectively, at December 31, 2002. Theincrease in these accounts is attributable to an emphasis on growing businessbanking, particularly at South Bay, which generates transaction depositaccounts.  Interest-bearing demanddeposits, which are largely limited to individuals, decreased to $28.1 millionat September 30, 2003 from $30.5 million at December 31, 2002.  Savings deposits increased to $43.4 millionat September 30, 2003 compared to $42.2 million at December 31, 2002 reflectingthe relative higher yields being paid on this deposit type.  Time certificates of deposit (“TCDs”)decreased significantly to $56.7 million at September 30, 2003 from $75.4million at December 31, 2002.  Thisdecrease is due to an emphasis on growing lower cost transaction accounts.Additionally, TCDs $100,000 and over decreased due to the termination of a$15.0 million public funds deposit partially offset by $5.0 million of brokeredTCDs in January 2003.  Brokered TCDs atSeptember 30, 2003 were $5.0 million. There were no brokered TCDs at December31, 2002.

 

30

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FEDERAL FUNDS SOLD AND SECURITIES SOLD UNDERAGREEMENTS TO REPURCHASE

 

Federal funds sold and securities sold under agreements to repurchaseat September 30, 2003 were $397,000 compared to $1.5 million at year-end2002.  The decline is due to the plannedrunoff of the higher costing liabilities at South Bay.

 

OTHER BORROWINGS

 

Otherborrowings were $7.5 million at September 30, 2003 and December 31, 2002 representingadvances from the Federal Home Loan Bank.

 

JUNIOR SUBORDINATED DEFERRABLE INTERESTDEBENTURES

 

JuniorSubordinated Debentures were $15.5 million at September 30, 2003, reflectingthe reclassification of trust preferred securities formerly reflected asminority interest.  See Note 9 in Notesto Consolidated Financial Statements.

 

SHAREHOLDERS’ EQUITY

 

Shareholders’ equity declined from $31.2 at December 31, 2002 to $30.9million at September 30, 2003 due to the net loss for the nine months endedSeptember 30, 2003 and the declines in market value of securitiesavailable-for-sale.

 

***CAPITAL ADEQUACY REQUIREMENTS***

 

At September 30, 2003 the Company and the Banks were in compliance withall applicable regulatory capital requirements and the Banks were “wellcapitalized” 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 forthe Company and the Banks as of September 30, 2003 and December 31, 2002.

 

31

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**Regulatory Capital Information**

**of the National MercantileBancorp and Banks**

 
|                             |   | **Minimum  For Capital  Adequacy  Purposes** |   | **Well  Capitalized  Standards** |   | **September  30,  2003** |   | **December  31,  2002** |   |
|----------------------------------|--------|----------------------------------------------|--------|----------------------------------|--------|--------------------------|--------|-------------------------|--------|
| **National Mercantile Bancorp:** |   |                                         |   |                             |   |                     |   |                    |   |
| Tier 1 leverage                  |   | 4.00                                         | %      | N/A                              |   | 8.50                     | %      | 8.60                    | %      |
| Tier 1 risk-based capital        |   | 4.00                                         | %      | N/A                              |   | 10.89                    | %      | 10.57                   | %      |
| Total risk-based capital         |   | 8.00                                         | %      | N/A                              |   | 13.69                    | %      | 13.31                   | %      |
|                             |   |                                         |   |                             |   |                     |   |                    |   |
| **Mercantile National Bank:**    |   |                                         |   |                             |   |                     |   |                    |   |
| Tier 1 leverage                  |   | 4.00                                         | %      | 5.00                             | %      | 7.38                     | %      | 7.20                    | %      |
| Tier 1 risk-based capital        |   | 4.00                                         | %      | 6.00                             | %      | 9.99                     | %      | 9.89                    | %      |
| Total risk-based capital         |   | 8.00                                         | %      | 10.00                            | %      | 11.25                    | %      | 11.15                   | %      |
|                             |   |                                         |   |                             |   |                     |   |                    |   |
| **South Bay Bank, NA:**          |   |                                         |   |                             |   |                     |   |                    |   |
| Tier 1 leverage                  |   | 4.00                                         | %      | 5.00                             | %      | 9.57                     | %      | 9.38                    | %      |
| Tier 1 risk-based capital        |   | 4.00                                         | %      | 6.00                             | %      | 12.15                    | %      | 10.90                   | %      |
| Total risk-based capital         |   | 8.00                                         | %      | 10.00                            | %      | 13.39                    | %      | 12.15                   | %      |

 

***LIQUIDITY***

 

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

 

The Company’s cash and due from banks was $22.6 million on September30, 2003 compared to $18.9 million on December 31, 2002.  Federal funds sold were $42.0 million and$18.7 million for September 30, 2003 and December 31, 2002, respectively.  Mercantile had $5.0 million and South Bayhad $12.0 million in Federal funds lines with correspondent banks as ofSeptember 30, 2003.

 

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 semi-annual interestpayments on the Junior Subordinated Debentures, under the terms of theindenture, are deferrable at the Company’s option, for a period up to tenconsecutive semi-annual payments, but in any event not beyond June 25, 2031.

 

National Mercantile’s cash and due from banks was $711,000 on September30, 2003 compared to $120,000 at December 31, 2002.

 

32

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The payment of dividends by National Mercantile is limited by the termsof the Trust Preferred Securities indenture. National Mercantile may not declare or pay any dividends or otherdistributions on its common stock or preferred stock if it is in default underthe terms of the indenture or if it has elected to defer payments of intereston the Trust Preferred Securities.

 

***ASSETLIABILITY MANAGEMENT***

 

The following table shows that the Company’s cumulative one-yearinterest rate sensitivity gap indicated an asset sensitive position of $63.8million at September 30, 2003, a change from an asset sensitive position of$41.2 million at December 31, 2002. This change resulted primarily from an increase in assets repricing inless than three months, consisting of federal funds sold, securities and duefrom banks – interest bearing partially offset by a decrease in adjustableloans receivable and securities available for sale.  Rate-sensitive liabilities increased only $947,000, consisting ofan increase in demand, money market and savings and other borrowings, offset bya decrease in time certificates of deposit.

 

The Company’s asset sensitive position during a period of slowlydeclining interest rates is not expected to have a significant negative impacton net interest income since rates paid on the Company’s large base of interestbearing demand, savings and money market deposit accounts historically have notchanged proportionately with changes in interest rates.  However, since the Company is in an assetsensitive position, in a period of rapidly declining rates, such as theenvironment that was experienced during 2001 and 2002, the rapid decline willhave a negative effect on the Company’s net interest income as changes in therates 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.

 

33

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**Rate-Sensitive Assets and Liabilities**

 
|                                                                     |   | **September  30, 2003  Maturing or repricing in** |   |
|--------------------------------------------------------------------------|--------|---------------------------------------------------|--------|
|                                                                     |   | **Less  than  three  months**                     |   | **After three  months  but within  one year** |   | **After one  year  but within  5 years** |   | **After  5 years** |   | **Total** |   |
|                                                                     |   | **(Dollars  in thousands)**                       |   |
| Rate-Sensitive Assets:                                                   |   |                                              |   |   |   |   |   |   |   |   |   |
| Federal funds sold and securities purchased under  agreements to resell  |   | $                                                 | 42,000 |   | $ | — |   | $ | — |   | $ | — |   | $ | 42,000 |   |
| Securities at amortized cost                                             |   | 15,924                                            |   | 615 |   | 5,056 |   | 14,524 |   | 36,119 |   |
| Due from banks - interest bearing                                        |   | 1,500                                             |   | 728 |   | — |   | — |   | 2,228 |   |
| FRB and other stock, at cost                                             |   | —                                            |   | — |   | — |   | 1,869 |   | 1,869 |   |
| Loans receivable (1)                                                     |   | 183,393                                           |   | 6,546 |   | 41,129 |   | 15,955 |   | 247,023 |   |
| Total rate-sensitive assets                                              |   | 242,817                                           |   | 7,889 |   | 46,185 |   | 32,348 |   | 329,239 |   |
|                                                                     |   |                                              |   |   |   |   |   |   |   |   |   |
| Rate-Sensitive Liabilities: (2)                                          |   |                                              |   |   |   |   |   |   |   |   |   |
| Interest bearing deposits:                                               |   |                                              |   |   |   |   |   |   |   |   |   |
| Demand, money market and savings                                         |   | 131,317                                           |   | — |   | — |   | — |   | 131,317 |   |
| Time certificates of deposit                                             |   | 24,950                                            |   | 24,787 |   | 6,571 |   | 379 |   | 56,687 |   |
| Other borrowings                                                         |   | —                                            |   | 5,897 |   | 2,000 |   | — |   | 7,897 |   |
| Total rate-sensitive liabilities                                         |   | 156,267                                           |   | 30,684 |   | 8,571 |   | 379 |   | 195,901 |   |
| Interest rate-sensitivity gap                                            |   | 86,550                                            |   | (22,795 | ) | 37,614 |   | 31,969 |   | 133,338 |   |
| Cumulative interest rate-sensitivity gap                                 |   | $                                                 | 86,550 |   | $ | 63,755 |   | $ | 101,369 |   | $ | 133,338 |   |   |   |
| Cumulative ratio of rate sensitive assets to  rate-sensitive liabilities |   | 155                                               | %      | 134 | % | 152 | % | 168 | % |   |   |
|                                                                          |        |                                                   |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1) Loans receivable excludes nonaccrual loans.

(2) Deposits which are subject to immediate withdrawal are presented asrepricing within three months or less.

The distribution of other time deposits is based on scheduledmaturities.

 

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|                                                                     |   | **December  31, 2002  Maturing or repricing in** |   |
|--------------------------------------------------------------------------|--------|--------------------------------------------------|--------|
|                                                                     |   | **Less  than  three  months**                    |   | **After  three  months  but within  one year** |   | **After one  year  but within  5 years** |   | **After  5 years** |   | **Total** |   |
|                                                                     |   | **(Dollars  in thousands)**                      |   |
| Rate-Sensitive Assets:                                                   |   |                                             |   |   |   |   |   |   |   |   |   |
| Federal funds sold and securities purchased under  agreements to resell  |   | $                                                | 18,700 |   | $ | — |   | $ | — |   | $ | — |   | $ | 18,700 |   |
| Securities available-for-sale, at amortized cost                         |   | —                                           |   | 998 |   | 1,857 |   | 22,969 |   | 25,824 |   |
| Due from banks - time                                                    |   | —                                           |   | 325 |   | — |   | — |   | 325 |   |
| FRB and other stock, at cost                                             |   | —                                           |   | — |   | — |   | 2,018 |   | 2,018 |   |
| Loans receivable (1)                                                     |   | 196,286                                          |   | 10,907 |   | 40,375 |   | 19,425 |   | 266,993 |   |
| Total rate-sensitive assets                                              |   | 214,986                                          |   | 12,230 |   | 42,232 |   | 44,412 |   | 313,860 |   |
|                                                                     |   |                                             |   |   |   |   |   |   |   |   |   |
| Rate-Sensitive Liabilities: (2)                                          |   |                                             |   |   |   |   |   |   |   |   |   |
| Interest bearing deposits:                                               |   |                                             |   |   |   |   |   |   |   |   |   |
| Demand, money market and savings                                         |   | 115,781                                          |   | — |   | — |   | — |   | 115,781 |   |
| Time certificates of deposit                                             |   | 36,882                                           |   | 31,865 |   | 6,617 |   | — |   | 75,364 |   |
| Other borrowings                                                         |   | —                                           |   | 1,476 |   | 7,500 |   | — |   | 8,976 |   |
| Total rate-sensitive liabilities                                         |   | 152,663                                          |   | 33,341 |   | 14,117 |   | — |   | 200,121 |   |
| Interest rate-sensitivity gap                                            |   | 62,323                                           |   | (21,111 | ) | 28,115 |   | 44,412 |   | 113,739 |   |
| Cumulative interest rate-sensitivity gap                                 |   | $                                                | 62,323 |   | $ | 41,212 |   | $ | 69,327 |   | $ | 113,739 |   |   |   |
| Cumulative ratio of rate sensitive assets to  rate-sensitive liabilities |   | 141                                              | %      | 122 | % | 135 | % | 157 | % |   |   |
|                                                                          |        |                                                  |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1) Loans receivable excludes nonaccrual loans.

(2) Deposits which are subject to immediate withdrawal are presented asrepricing within three months or less.

The distribution of other time deposits is based on scheduledmaturities.

 

InOctober 2002,  Mercantile executed aninformal non-binding memorandum of understanding (“MOU”),  with the OCC relating to its interest raterisk management.  The MOU provided forMercantile to take certain actions that the OCC believed would strengthenMercantile’s interest rate risk management process, including the review of itsinterest rate risk limits and interest rate risk modeling assumptions and theretention of an independent consultant to conduct a review of Mercantile’sinterest rate risk measurement processes. Mercantile completed the actions provided in the MOU and was informed bythe OCC that the MOU has been terminated.

 

35

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**FACTORS WHICH MAY AFFECT FUTURE OPERATINGRESULTS**

 

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

 

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

 

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

 

•                  Our abilityto originate loans;

 

•                  The abilityof our borrowers to make payments on their loans;

 

•                  The value ofour interest-earning assets and our ability to realize gains from the sale ofthese assets;

 

•                  The averagelife of our interest-earning assets;

 

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

 

•                  Our 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 our control.

 

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

 

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

 

**Our allowances for creditlosses may be inadequate.**

 

We establish allowances for credit losses against each segment of ourloan portfolio.  At September 30, 2003,our allowance for credit losses equaled 1.5% of loans receivable and 727.8% ofnonperforming loans.  Although webelieved that we had established adequate allowances for credit losses as ofSeptember 30, 2003, the credit quality of our assets is affected by manyfactors beyond our control, including local and national economic conditions,and the possible existence of facts

 

36

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which are not known to us which adversely affect the likelihood ofrepayment of various loans in our loan portfolio and realization of thecollateral upon a default.  Accordingly,we can give no assurance that we will not sustain loan losses materially inexcess of the allowance for credit losses. In addition, the Office of the Comptroller of the Currency, as anintegral part of its examination process, periodically reviews our allowancefor credit losses and could require additional provisions for creditlosses.  Material future additions tothe allowance for credit losses may also be necessary due to increases in thesize and changes in the composition of our loan portfolio.  Increases in our provisions for creditlosses would adversely affect our results of operations.

 

**Economic conditions may worsen.**

 

Ourbusiness is strongly influenced by economic conditions in our market area(principally, the Greater Los Angeles metropolitan area) as well as regionaland national economic conditions and in our niche markets, including theentertainment industry in Southern California. During the past several years economic conditions in these areas havebeen generally unfavorable.  Should theeconomic condition in these areas continue to be unfavorable, the financialcondition of our borrowers could weaken, which could lead to higher levels ofloan defaults or a decline in the value of collateral for our loans.  In addition, an unfavorable economy couldreduce the demand for our loans and other products and services.

 

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

 

AtSeptember 30, 2003, a large majority of our loans outstanding werecollateralized by real properties located in California.  Because of this concentration in California,our financial position and results of operations have been and are expected tocontinue to be influenced by general trends in the California economy and itsreal estate market.  Real estate marketdeclines may adversely affect the values of the properties collateralizingloans.  If the principal balances of ourloans, together with any primary financing on the mortgaged properties, equalor exceed the value of the mortgaged properties, we could incur higher losseson sales of properties collateralizing foreclosed loans.  In addition, California historically hasbeen vulnerable 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 our ability to recoverlosses on properties affected by such disasters and adversely impact ourresults of operations.

 

**Our business is very competitive.**

 

Thereis intense competition in Southern California and elsewhere in the UnitedStates for banking customers.  Weexperience competition for deposits from many sources, including credit unions,insurance companies and money market and

 

37

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other mutual funds, as well as other commercial banks and savingsinstitutions.  We compete for loans anddeposits primarily 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 our competitors have greaterfinancial strength, marketing capability and name recognition than we do, andoperate on a statewide or nationwide basis. In addition, recent developments in technology and mass marketing havepermitted larger companies to market loans more aggressively to our smallbusiness customers.  Such advantages maygive our competitors opportunities to realize greater efficiencies andeconomies of scale than we can.  We canprovide no assurance that we will be able to compete effectively against ourcompetition.

** **

**Our business is heavily regulated.**

 

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

 

**We testgoodwill annually and must record any impairment as a charge to earnings**.

 

Statementof Financial Accounting Standards No. 142 “Goodwill and Other IntangibleAssets” (“SFAS No. 142”), among other provisions, prescribes that goodwill andintangible assets that have indefinite useful lives will not be amortized butrather tested annually, or more frequently upon the occurrence of certain events,for impairment.  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.

 

Werecorded goodwill of $2.2 million in connection with the South Bay acquisitionin December 2001.  During the fourthquarter of 2002, we completed the required impairment tests of goodwill.  The tests determined that our goodwill wasnot considered impaired.  No assurancecan be given that our goodwill will not become impaired in the future.

** **

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

 

Inconjunction with the acquisition of South Bay, we reversed our valuationallowance of $6.9 million on the deferred tax asset with the related benefitreducing goodwill.  On a periodic basis,at least annually, we perform an analysis to determine if

 

38

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it is more likely than not that some or all of the gross deferred taxasset will not be realized.  Factorsused in the analysis that are reflective of the future realization of adeferred tax asset are:

 

•                  A relativelyconsistent strong earnings history;

 

•                  Futureearnings are assured;

 

•                  Expectedadequate future taxable income arising from the reversal of temporarydifferences to realize the tax asset;

 

An evaluation allowancemay be established to reduce the deferred tax asset to its realizablevalue.  The determination of whether avaluation allowance is necessary involves considering the positive and negativefactors related to whether the deferred tax asset is more likely than not to berealized.  Any adjustment required tothe valuation allowance is coupled with a related entry to income taxexpense.  A charge to earnings will bemade in the event that we determine that a valuation allowance to the deferredtax asset is necessary.

 

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

 

TheCompany’s management, with the participation of the Chief Executive Officer andChief Financial Officer, has conducted an evaluation of the effectiveness ofthe Company’s disclosure controls and procedures pursuant to Rule 13a-14 underthe Securities Exchange Act of 1934, as amended, as of the end of the periodcovered by this report. Based on that evaluation, the Chief Executive Officerand the Chief Financial Officer believe that the Company’s disclosure controlsand procedures reasonable ensure that information required to be disclosedby the Company in this quarterly report has been made known to them in a timelymanner.

 

There was no change inthe Company’s internal control over financial reporting during the Company’smost recently completed fiscal quarter that has materially affected, or isreasonabley likely to materially affect, the Company’s internal control overfinancial reporting.

 

39

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**PART II—OTHERINFORMATION**

 

***Item 1.***          LEGALPROCEEDINGS

 

None.

 

***Item 2.******          CHANGESIN SECURITIES***

 

None.

 

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

 

None.

 

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

 

None.

 

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

 

None.

 

***Item 6.******          EXHIBITSAND REPORTS ON FORM 8-K***

 
| (a) *Exhibits.*            |   |
|----------------------------|--------|
|                       |   |
|                       |   | 31.1 Certification of Scott  A. Montgomery on disclosure controls. |
|                       |   | 31.2 Certification of David  R. Brown on disclosure controls. |
|                       |   | 32.1 Certification of Scott  A. Montgomery pursuant to section 906 of the Sarbanes-Oxley Act of 2002 |
|                       |   | 32.2 Certification of David  R. Brown pursuant to section 906 of the Sarbanes-Oxley Act of 2002 |
|                       |
| (b) *Reports on Form 8-K.* |
|                       |   |   |
|                       |   | Form 8-K, reporting the Company’s press release regarding second  quarter 2003 operating results was filed August 6, 2003. |
|                            |        |  |  |

 

40

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|   |              | **National Mercantile  Bancorp**                      |                                |
|--------|-------------------|-------------------------------------------------------|-------------------------------------|
|   |              | (Registrant)                                          |
|   |              |                                                  |                                |
| DATE:  | November 14, 2003 |                                                  | /s/  Scott A.  Montgomery |   |
|   |              | **Scott A. Montgomery**                               |
|   |              | Chief Executive Officer                               |
|   |              |                                                  |                                |
| DATE:  | November 14, 2003 |                                                  | /s/  David R. Brown       |   |
|   |              | **David R. Brown**                                    |
|   |              | Principal Financial and Principal Accounting  Officer |
|        |                   |                                                       |                                     |  |  |  |

 

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