** **

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

 

**WASHINGTON,D.C. 20549**

** **

**FORM 10-QSB**

** **

**QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE**

# **SECURITIES EXCHANGE ACT OF 1934**

** **

**For the quarterlyperiod ended June 30, 2003 Commission File Number: 0-15982**

** **

**NATIONAL MERCANTILE BANCORP**

(Exact name of smallbusiness issuer as specified in its charter) 

** **

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

 

| **1840  Century Park East, Los Angeles, California** |   | **90067**  |
|------------------------------------------------------|--------|------------|
| (Address of principal  executive offices)            |   | (Zip Code) |

 

Issuer’s telephonenumber, 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 |
|-----|--------|--------|----|---|

 

 

APPLICABLEONLY TO CORPORATE ISSUERS:

 

The number ofshares outstanding of the issuer’s Common Stock, no par value, as of August 14,2003 was 2,700,929.

 

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

 

 

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**NATIONALMERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

 

| ** **                                                                                                                                                                                     |   | **June 30, 2003**          |    | **December 31, 2002** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------|---------|-----------------------|--------|
|                                                                                                                                                                                           |   | **(Unaudited)**            |    |                  |   |
|                                                                                                                                                                                           |   | **(Dollars in thousands)** |    |
| ASSETS                                                                                                                                                                                         |   |                       |    |                  |   |
| Cash and due  from banks-demand                                                                                                                                                                |   | $                          | 18,625  |                  | $      | 18,876 |   |
| Federal funds  sold and securities purchased under agreements to resell                                                                                                                        |   | 39,900                     |    | 18,700                |   |
| Cash and cash  equivalents                                                                                                                                                                     |   | 58,525                     |    | 37,576                |   |
| Securities  available-for-sale, at fair value; aggregate amortized cost of $21,548 and  $25,824 at June 30, 2003 and December 31, 2002, respectively                                           |   | 21,674                     |    | 26,170                |   |
| Due from  banks-time                                                                                                                                                                           |   | 325                        |    | 325                   |   |
| FRB and other  stock, at cost                                                                                                                                                                  |   | 1,866                      |    | 2,018                 |   |
| Loans receivable                                                                                                                                                                               |   | 266,150                    |    | 272,323               |   |
| Allowance for  credit losses                                                                                                                                                                   |   | (3,452                     | )       | (4,846                | )      |
| Net loans  receivable                                                                                                                                                                          |   | 262,698                    |    | 267,477               |   |
|                                                                                                                                                                                           |   |                       |    |                  |   |
| Premises and  equipment, net                                                                                                                                                                   |   | 5,639                      |    | 5,836                 |   |
| Other real  estate owned                                                                                                                                                                       |   | 1,000                      |    | 1,000                 |   |
| Deferred tax  asset                                                                                                                                                                            |   | 8,087                      |    | 7,984                 |   |
| Goodwill                                                                                                                                                                                       |   | 2,174                      |    | 2,174                 |   |
| Core deposit  intangibles, net                                                                                                                                                                 |   | 1,965                      |    | 2,077                 |   |
| Accrued interest  receivable and other assets                                                                                                                                                  |   | 2,350                      |    | 2,748                 |   |
| Total assets                                                                                                                                                                                   |   | $                          | 366,303 |                  | $      | 355,385 |   |
|                                                                                                                                                                                           |   |                       |    |                  |   |
| LIABILITIES AND SHAREHOLDERS’  EQUITY                                                                                                                                                     |   |                       |    |                  |   |
| Deposits:                                                                                                                                                                                      |   |                       |    |                  |   |
| Noninterest-bearing  demand                                                                                                                                                                    |   | $                          | 123,569 |                  | $      | 107,580 |   |
| Interest-bearing  demand                                                                                                                                                                       |   | 27,644                     |    | 30,465                |   |
| Money market                                                                                                                                                                                   |   | 51,272                     |    | 43,134                |   |
| Savings                                                                                                                                                                                        |   | 46,783                     |    | 42,182                |   |
| Time  certificates of deposit:                                                                                                                                                                 |   |                       |    |                  |   |
| $100,000 or more                                                                                                                                                                               |   | 30,147                     |    | 43,006                |   |
| Under $100,000                                                                                                                                                                                 |   | 32,536                     |    | 32,358                |   |
| Total deposits                                                                                                                                                                                 |   | 311,951                    |    | 298,725               |   |
|                                                                                                                                                                                           |   |                       |    |                  |   |
| Federal funds  purchased and securities sold under agreements to repurchase                                                                                                                    |   | 395                        |    | 1,476                 |   |
| Other borrowings                                                                                                                                                                               |   | 7,500                      |    | 7,500                 |   |
| Accrued interest  payable and other liabilities                                                                                                                                                |   | 1,206                      |    | 1,950                 |   |
| Total  liabilities                                                                                                                                                                             |   | 321,052                    |    | 309,651               |   |
|                                                                                                                                                                                           |   |                       |    |                  |   |
| Guaranteed  preferred beneficial interests in the Company’s junior subordinated  deferrable interest debentures, net                                                                      |   | 14,538                     |    | 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 June 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 2,696,729 and 2,679,544  shares at June 30, 2003 and December 31, 2002, respectively                                    |   | 38,131                     |    | 38,054                |   |
| Accumulated  deficit                                                                                                                                                                           |   | (14,476                    | )       | (14,055               | )      |
| Accumulated  other comprehensive income                                                                                                                                                        |   | 73                         |    | 202                   |   |
| Total  shareholders’ equity                                                                                                                                                               |   | 30,713                     |    | 31,204                |   |
| Total  liabilities and shareholders’ equity                                                                                                                                               |   | $                          | 366,303 |                  | $      | 355,385 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

3

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**NATIONALMERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

(Unaudited)

 

| ** **                                                                                                                                                                                                                          |   | **For the Three Months Ended June 30,**           |   | **For the Six Months Ended June 30,** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------------------|--------|---------------------------------------|--------|
|                                                                                                                                                                                                                                |   | **2003**                                          |   | **2002**                              |   | **2003** |   | **2002** |   |
| ** **                                                                                                                                                                                                                          |   | **(Dollars in thousands, except per share data)** |   |
| Interest income:                                                                                                                                                                                                                    |   |                                              |   |                                  |   |   |   |   |   |
| Loans, including  fees                                                                                                                                                                                                              |   | $                                                 | 4,090  |                                  | $      | 4,361 |   | $ | 8,207 |   | $ | 8,752 |   |
| Securities  available-for-sale                                                                                                                                                                                                      |   | 159                                               |   | 447                                   |   | 409 |   | 930 |   |
| Federal funds  sold and securities purchased under agreements to resell                                                                                                                                                             |   | 133                                               |   | 129                                   |   | 176 |   | 256 |   |
| Total interest  income                                                                                                                                                                                                              |   | 4,382                                             |   | 4,937                                 |   | 8,792 |   | 9,938 |   |
| Interest  expense:                                                                                                                                                                                                                  |   |                                              |   |                                  |   |   |   |   |   |
| Interest-bearing  demand                                                                                                                                                                                                            |   | 28                                                |   | 85                                    |   | 89 |   | 157 |   |
| Money market and  savings                                                                                                                                                                                                           |   | 254                                               |   | 371                                   |   | 555 |   | 699 |   |
| Time  certificates of deposit:                                                                                                                                                                                                      |   |                                              |   |                                  |   |   |   |   |   |
| $ 100,000 or  more                                                                                                                                                                                                                  |   | 119                                               |   | 194                                   |   | 266 |   | 501 |   |
| Under $100,000                                                                                                                                                                                                                      |   | 237                                               |   | 355                                   |   | 519 |   | 760 |   |
| Total interest  expense on deposits                                                                                                                                                                                                 |   | 638                                               |   | 1,005                                 |   | 1,429 |   | 2,117 |   |
| Federal funds  purchased and securities sold under agreements to repurchase                                                                                                                                                         |   | 3                                                 |   | 58                                    |   | 11 |   | 95 |   |
| Other borrowings                                                                                                                                                                                                                    |   | 89                                                |   | 146                                   |   | 178 |   | 296 |   |
| Total interest  expense                                                                                                                                                                                                             |   | 730                                               |   | 1,209                                 |   | 1,618 |   | 2,508 |   |
| Net interest  income before provision for credit losses                                                                                                                                                                             |   | 3,652                                             |   | 3,728                                 |   | 7,174 |   | 7,430 |   |
| Provision for  credit losses                                                                                                                                                                                                        |   | 1,145                                             |   | 150                                   |   | 1,255 |   | 300 |   |
| Net interest  income after provision for credit losses                                                                                                                                                                              |   | 2,507                                             |   | 3,578                                 |   | 5,919 |   | 7,130 |   |
| Other operating  income:                                                                                                                                                                                                            |   |                                              |   |                                  |   |   |   |   |   |
| Net gain on sale  of securities available-for-sale                                                                                                                                                                                  |   | —                                            |   | —                                |   | 100 |   | — |   |
| International  services                                                                                                                                                                                                             |   | 7                                                 |   | 14                                    |   | 15 |   | 19 |   |
| Investment  division                                                                                                                                                                                                                |   | 22                                                |   | 20                                    |   | 44 |   | 42 |   |
| Deposit-related  and other customer services                                                                                                                                                                                        |   | 316                                               |   | 252                                   |   | 621 |   | 621 |   |
| Gain (loss) on  sale of OREO/fixed assets                                                                                                                                                                                           |   | (61                                               | )      | —                                |   | (61 | ) | — |   |
| Total other  operating income                                                                                                                                                                                                       |   | 284                                               |   | 286                                   |   | 719 |   | 682 |   |
| Other operating  expenses:                                                                                                                                                                                                          |   |                                              |   |                                  |   |   |   |   |   |
| Salaries and  related benefits                                                                                                                                                                                                      |   | 1,843                                             |   | 1,766                                 |   | 3,670 |   | 3,405 |   |
| Net occupancy                                                                                                                                                                                                                       |   | 344                                               |   | 349                                   |   | 673 |   | 722 |   |
| Furniture and  equipment                                                                                                                                                                                                            |   | 125                                               |   | 113                                   |   | 234 |   | 214 |   |
| Printing and  communications                                                                                                                                                                                                        |   | 133                                               |   | 139                                   |   | 262 |   | 311 |   |
| Insurance and  regulatory assessments                                                                                                                                                                                               |   | 84                                                |   | 87                                    |   | 195 |   | 178 |   |
| Client services                                                                                                                                                                                                                     |   | 142                                               |   | 255                                   |   | 320 |   | 446 |   |
| Computer data  processing                                                                                                                                                                                                           |   | 249                                               |   | 284                                   |   | 465 |   | 512 |   |
| Legal services                                                                                                                                                                                                                      |   | 117                                               |   | 206                                   |   | 260 |   | 380 |   |
| Other  professional services                                                                                                                                                                                                        |   | 182                                               |   | 243                                   |   | 407 |   | 317 |   |
| Amortization of  core deposit intangible                                                                                                                                                                                            |   | 56                                                |   | —                                |   | 112 |   | — |   |
| Promotion and  other expenses                                                                                                                                                                                                       |   | 135                                               |   | (43                                   | )      | 222 |   | 197 |   |
| Total other  operating expenses                                                                                                                                                                                                     |   | 3,410                                             |   | 3,399                                 |   | 6,820 |   | 6,682 |   |
| Income before  income tax provision and minority interest                                                                                                                                                                           |   | (619                                              | )      | 465                                   |   | (182 | ) | 1,130 |   |
|                                                                                                                                                                                                                                |   |                                              |   |                                  |   |   |   |   |   |
| Minority  interest in the Company’s income of the:                                                                                                                                                                             |   |                                              |   |                                  |   |   |   |   |   |
| Guaranteed  preferred beneficial interests in the Company’s junior subordinated  deferrable interest debentures, net                                                                                                           |   | 223                                               |   | 389                                   |   | 456 |   | 773 |   |
| Series A  Preferred Stock of South Bay Bank, N.A.                                                                                                                                                                                   |   | —                                            |   | 106                                   |   | — |   | 106 |   |
|                                                                                                                                                                                                                                |   |                                              |   |                                  |   |   |   |   |   |
| Income (loss)  before income tax (benefit) provision                                                                                                                                                                                |   | (842                                              | )      | (30                                   | )      | (638 | ) | 251 |   |
|                                                                                                                                                                                                                                |   |                                              |   |                                  |   |   |   |   |   |
| Income tax  (benefit) provision                                                                                                                                                                                                     |   | (323                                              | )      | 32                                    |   | (216 | ) | 138 |   |
| Net income  (loss)                                                                                                                                                                                                                  |   | $                                                 | (519   | )                                     | $      | (62 | ) | $ | (422 | ) | $ | 113 |   |
| Income (loss)  available to common shareholders (net income (loss) less accretion of  discount of minority interest in subsidiary preferred stock of $72,000 and  $151,000 for the three months and six months ended June 30, 2002) |   | $                                                 | (519   | )                                     | (134   | ) | $ | (422 | ) | (38 | ) |
| Loss per share:                                                                                                                                                                                                                     |   |                                              |   |                                  |   |   |   |   |   |
| Basic                                                                                                                                                                                                                               |   | $                                                 | (0.19  | )                                     | $      | (0.08 | ) | $ | (0.16 | ) | $ | (0.02 | ) |
| Diluted                                                                                                                                                                                                                             |   | $                                                 | (0.19  | )                                     | $      | (0.08 | ) | $ | (0.16 | ) | $ | (0.02 | ) |

 

See accompanying notes to consolidated financial statements. 

 

4

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**NATIONAL****MERCANTILE****BANCORP ANDSUBSIDIARIES**

**CONSOLIDATED****STATEMENTS OF CASHFLOWS**

(Unaudited)

 

 
|                                                                                        |   | **For the Six Months Ended June 30,** |   |
|---------------------------------------------------------------------------------------------|--------|---------------------------------------|--------|
|                                                                                        |   | **2003**                              |   | **2002** |   |
|                                                                                        |   | **(Dollars in thousands)**            |   |
| Cash flows from  operating activities:                                                      |   |                                  |   |   |   |
| Net income  (loss)                                                                          |   | $                                     | (422   | ) | $ | 113 |   |
| Adjustments to  reconcile net income to net cash used in operating activities:              |   |                                  |   |   |   |
| Depreciation and  amortization                                                              |   | 246                                   |   | 183 |   |
| Provision for  credit losses                                                                |   | 1,255                                 |   | 300 |   |
| Gain on sale of  securities available for sale                                              |   | (100                                  | )      | — |   |
| Loss on sales of  OREO                                                                      |   | 61                                    |   | — |   |
| Net amortization  of premium on securities available-for-sale                               |   | 113                                   |   | 87 |   |
| Net amortization  of core deposit intangible                                                |   | 112                                   |   | — |   |
| Net amortization  of premium (discount) on loans purchased                                  |   | 143                                   |   | 186 |   |
| Decrease in  accrued interest receivable and other assets                                   |   | 387                                   |   | 798 |   |
| Decrease in  accrued interest payable and other liabilities                                 |   | (744                                  | )      | (876 | ) |
| Net cash  provided by operating activities                                                  |   | 1,051                                 |   | 791 |   |
| Cash flows from  investing activities:                                                      |   |                                  |   |   |   |
| Purchase of  securities available-for-sale                                                  |   | (14,536                               | )      | (2,539 | ) |
| Proceeds from  sales of securities available-for-sale                                       |   | 2,757                                 |   | — |   |
| Proceeds from  repayments and maturities of securities available-for-sale                   |   | 16,042                                |   | 14,668 |   |
| Proceeds from  sales of OREO                                                                |   | 474                                   |   | — |   |
| Loan  originations and principal collections, net                                           |   | 2,846                                 |   | 4,116 |   |
| Redemption of  Federal Reserve stock and other stocks                                       |   | 152                                   |   | 329 |   |
| Purchases of  premises and equipment                                                        |   | (41                                   | )      | (170 | ) |
| Net cash  provided by investing activities                                                  |   | 7,694                                 |   | 16,404 |   |
| Cash flows from  financing activities:                                                      |   |                                  |   |   |   |
| Net increase in  demand deposits, money market and savings accounts                         |   | 25,907                                |   | 8,924 |   |
| Net decrease in  time certificates of deposit                                               |   | (12,681                               | )      | (19,002 | ) |
| Net decrease in  securities sold under agreements to repurchase and federal funds purchased |   | (1,081                                | )      | (1,123 | ) |
| Net decrease in  other borrowings                                                           |   | —                                |   | (2,000 | ) |
| Net proceeds  from exercise of stock options                                                |   | 59                                    |   | 27 |   |
| Net cash  provided by (used in) financing activities                                        |   | 12,204                                |   | (13,174 | ) |
| Net increase in  cash and cash equivalents                                                  |   | 20,949                                |   | 4,021 |   |
| Cash and cash equivalents,  January 1                                                       |   | 37,576                                |   | 52,093 |   |
| Cash and cash  equivalents, June 30                                                         |   | $                                     | 58,525 |   | $ | 56,114 |   |
|                                                                                        |   |                                  |   |   |   |
| Supplemental  disclosures of cash flow information:                                         |   |                                  |   |   |   |
| Cash paid for  Interest                                                                     |   | $                                     | 2,207  |   | $ | 2,454 |   |
| Transfers to  OREO from loans receivable, net                                               |   | $                                     | 535    |   | $ | — |   |

 

See accompanying notes to consolidated financial statements. 

 

5

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**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

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

 

 

NOTE 1—BASIS OF PRESENTATIONAND MANAGEMENT REPRESENTATIONS

 

The unaudited consolidated financial statements include the accounts ofNational Mercantile Bancorp (the ‘‘Company’’) and its wholly ownedsubsidiaries, Mercantile National Bank, South Bay Bank, N.A., and NationalMercantile Capital Trust I.  Theunaudited consolidated financial statements reflect all interim adjustments,which are of a normal recurring nature and which, in management’s opinion, arenecessary for the fair presentation of the Company’s consolidated financialposition and results of operations and cash flows for such interim periods. Theresults for the three and six months ended June 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 the FinancialAccounting Standards Board issued Statement of Financial Accounting StandardsNo. 148, (“SFAS No. 148”), Accounting for Stock-Based Compensation-Transitionand Disclosure.  SFAS No. 148 amends Statementof Financial Accounting Standards No. 123, (“SFAS No. 123”), Accounting forStock-Based Compensation, to provide alternative methods of transition for avoluntary change to the fair value based method of accounting for stock-basedemployee compensation.  In addition,SFAS No.148 amends the disclosure requirements of SFAS No. 123 to requireprominent disclosures in both 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 share weightedaverage fair value of options granted was $4.81 and $4.17 for the three monthsended June 30, 2003 and 2002, respectively. The estimated per share weighted average fair value of options grantedwas $4.73 and $3.79 for the six months ended June 30, 2003 and 2002,respectively.  The Company appliesAccounting Principles Board Opinion No. 25 and related Interpretations inaccounting for the stock incentive plans. SFAS No. 123, Accounting for Stock-Based Compensation, encourages, butdoes not require, companies to record compensation cost for stock-basedemployee compensation plans at fair value. Accordingly, no compensation cost has been recognized for theplans.  Had compensation cost for theoptions granted been determined based on the fair value at the grant dates forawards under the plans consistent

 

6

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with the method ofSFAS No. 123, the Company’s net income for the three months ended June 30, 2003and 2002 and the six months ended June 30, 2003 and 2002 would have decreasedby $28,000 and $23,000, and $66,000 and $46,000 respectively.  Basic and diluted loss per share would haveincreased by $0.01 for the three months ended June 30, 2003 and by $0.02 forthe six months ended June 30, 2003. Basic loss per share would have increased by $0.02 for the three monthsended June 30, 2002 and by $0.03 for the six months ended June 30, 2002 anddiluted loss per share would have remained unchanged.

 

         The fair values of options grantedduring the three months ended June 30, 2003 and 2002 were estimated on the dateof grant using the Black-Scholes option-pricing model with the followingweighted-average assumptions used: 2003— no dividend yield, expected volatilityof 59%, risk-free interest rate of 3.50%, and an expected life of 10 years;2002— no dividend yield, expected volatility of 64%, risk-free interest rate of4.81%, and an expected life of 10 years.

 

 

NOTE 2—EARNINGS PER SHARE

 

         Basic earnings or loss per share iscomputed using the weighted average number of common shares outstanding duringthe period.  The weighted average numberof common shares outstanding used in computing basic and diluted loss per sharefor the three months ended June 30, 2003 and 2002 was 2,695,366 and 1,631,451,respectively and 2,691,485 and 1,629,320, respectively, for the six monthsended June 30, 2003 and 2002.  Commonshare equivalents have not been included in the loss per share computation asthey are anti-dilutive.

 

         The following table is a reconciliationof income and shares used in the computation of basic and diluted loss pershare:

 

7

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| ** **                                   |   | **Earnings available to shareholders** |   | **Weighted Average Shares** |      | **Per share amount** |   |
|----------------------------------------------|--------|----------------------------------------|--------|-----------------------------|-----------|----------------------|--------|
|                                         |   | **(in thousands)**                     |   |                        |      |                 |   |
| *For  the three months ended June 30, 2003:* |   |                                   |   |                        |      |                 |   |
| Basic and  diluted loss per share            |   | $                                      | (519   | )                           | 2,695,366 |                 | $      | (0.19 | ) |
|                                         |   |                                   |   |                        |      |                 |   |
| *For  the three months ended June 30, 2002:* |   |                                   |   |                        |      |                 |   |
| Basic and  diluted loss per share            |   | $                                      | (134   | )                           | 1,631,451 |                 | $      | (0.08 | ) |
|                                         |   |                                   |   |                        |      |                 |   |
| *For  the six months ended June 30, 2003:*   |   |                                   |   |                        |      |                 |   |
| Basic and  diluted loss per share            |   | $                                      | (422   | )                           | 2,691,485 |                 | $      | (0.16 | ) |
|                                         |   |                                   |   |                        |      |                 |   |
| *For  the six months ended June 30, 2002:*   |   |                                   |   |                        |      |                 |   |
| Basic and  diluted loss per share            |   | $                                      | (38    | )                           | 1,629,320 |                 | $      | (0.02 | ) |

 

 

NOTE 3—CASH AND CASHEQUIVALENTS

 

For purposes of reporting cash flows, cash and cash equivalents includecash and due from banks-demand and federal funds sold.

 

NOTE 4—ALLOWANCE FORCREDIT LOSSES 

 

Provisions for credit losses charged to operations reflect management’sjudgment of the adequacy of the allowance for credit losses and are determinedthrough periodic analysis of the loan portfolio.  This analysis includes a detailed review of the classificationand categorization of problem loans and loans to be charged off; an assessmentof the overall quality and collectibility of the portfolio; and considerationof the loan loss experience, trends in problem loan concentrations of creditrisk, as well as current and expected future economic conditions (particularlySouthern California). Management performs a periodic risk and credit analysis,the results of which are reported to the Board of Directors.  Loans charged off during the three monthsended June 30, 2003 were $2.4 million compared to $401,000 during the threemonths ended June 30, 2002. Recoveries of loans previously charged off were$54,000 during the three months ended June 30, 2003 compared to $176,000 forthe same period in 2002. Loans charged off during the six months ended June 30,2003 were $2.8 million compared to $1.8 million during the six months endedJune 30, 2002. Recoveries of loans previously charged off were $194,000 duringthe six months ended June 30, 2003 compared to $336,000 for the same period in2002. 

 

8

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The following sets forth information concerning the Company's allowancefor credit losses for the periods indicated.

 
|                                                     |   | **Three months ended**     |   | **Six months ended**       |   |
|----------------------------------------------------------|--------|----------------------------|--------|----------------------------|--------|
| ** **                                               |   | **June 30, 2003**          |   | **June 30, 2002**          |   | **June 30, 2003** |   | **June 30, 2002** |   |
|                                                     |   | **(Dollars in thousands)** |   | **(Dollars in thousands)** |   |
| Balance,  beginning of period                            |   | $                          | 4,694  |                       | $      | 5,449 |   | $ | 4,846 |   | $ | 6,542 |   |
| Loans charged  off:                                      |   |                       |   |                       |   |   |   |   |   |
| Real estate  construction and land development           |   | —                     |   | —                     |   | — |   | 31 |   |
| Commercial  loans:                                       |   |                       |   |                       |   |   |   |   |   |
| Secured by one  to four family residential properties    |   | 15                         |   | —                     |   | 38 |   | — |   |
| Secured by  commercial real properties                   |   | 75                         |   | —                     |   | 75 |   | — |   |
| Other – secured  and unsecured                      |   | 2,318                      |   | 400                        |   | 2,697 |   | 1,742 |   |
| Consumer  installment and unsecured loans to individuals |   | 33                         |   | 1                          |   | 33 |   | 31 |   |
|                                                     |   |                       |   |                       |   |   |   |   |   |
| Total loans  charged-off                                 |   | 2,441                      |   | 401                        |   | 2,843 |   | 1,804 |   |
|                                                     |   |                       |   |                       |   |   |   |   |   |
| Recoveries of  loans previously charged off:             |   |                       |   |                       |   |   |   |   |   |
| Real estate  construction and land development           |   | —                     |   | 84                         |   | — |   | 191 |   |
| Commercial  loans:                                       |   |                       |   |                       |   |   |   |   |   |
| Secured by  commercial real properties                   |   | —                     |   | —                     |   | — |   | — |   |
| Other – secured  and unsecured                      |   | 47                         |   | 47                         |   | 133 |   | 95 |   |
| Consumer  installment and unsecured loans to individuals |   | 7                          |   | 45                         |   | 61 |   | 50 |   |
| Total recoveries  of loans previously charged off        |   | 54                         |   | 176                        |   | 194 |   | 336 |   |
| Net charge-offs                                          |   | 2,387                      |   | 225                        |   | 2,649 |   | 1,468 |   |
| Provision for  credit losses                             |   | 1,145                      |   | 150                        |   | 1,255 |   | 300 |   |
| Balance, end of  period                                  |   | $                          | 3,452  |                       | $      | 5,374 |   | $ | 3,452 |   | $ | 5,374 |   |

 

 

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

 

NOTE 5—GOODWILLAND OTHER INTANGIBLE ASSETS

 

         As of June 30, 2003 and December 31,2002, the Company had goodwill of $2.2 million, and net core depositintangibles of $2.0 million and $2.1 million, respectively, from the South BayBank acquisition.  The gross carryingamount of core deposit intangibles was $2.3 million at June 30, 2003 and December31, 2002, and accumulated amortization was $339,000

 

9

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and $223,000,respectively, at such dates.  The coredeposit intangibles are estimated to have a life of 10 years and 4 months.Amortization for intangibles for 2003 and each of the next four years isestimated to be $223,000 per year.  Inaccordance with SFAS No. 142 goodwill is not amortized.  The Company has no other indefinite-livedintangible assets.

 

NOTE 6—INCOMETAXES

 

Income tax benefit of $323,000 and provision of $32,000 were recordedfor the three months ended June 30, 2003 and 2002, respectively.  Income tax benefit of $216,000 and provisionof $138,000 were recorded for the six months ended June 30, 2003 and 2002,respectively. The difference between the statutory tax rate and the effectivetax rate for the three and six months ended June 30, 2003 is due to theamortization of the core deposit intangible not being deductible for taxpurposes.

 

At June 30, 2003, the Company had: (i) federal net operating loss carryforwards (“NOLS”) of approximately $17.9 million, which begin to expire in theyear 2009; (ii) California NOLS of $559,000 which will expire in 2005; (iii) afederal alternative minimum tax “AMT” credit of $298,000; and (iv) a CaliforniaAMT of $16,000.  The AMT credits carryforward indefinitely.

 

NOTE 7—BENEFICIALCONVERSION RIGHTS OF SUBSIDIARY PREFERRED STOCK

 

In connection with its acquisition of South Bay Bank in December 2001,the Company recorded $1.8 million additional paid in capital, with acorresponding discount to the minority interest in the South Bay Series APreferred stock, which remained outstanding following the acquisition, relatedto the beneficial conversion rights of such preferred stock.  The discount was being amortized againstretained 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 six months ended June 30, 2002 the amount of the discount amortizedagainst retained earnings was  $72,000and $151,000, respectively. The amortization of the discount was netted againstnet income to determine income available to common shareholders for earningsper share in the 2002 period.  The SouthBay Series A Preferred stock was fully redeemed in December 2002.

 

NOTE8—COMPREHENSIVE INCOME

 

Comprehensive income is comprised of net income and all changes toshareholders’ equity, except those changes resulting from investments byshareholders and distributions to shareholders.  Total comprehensive income is as follows:

 

10

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| ** **                                               |   | **For the three months ended June 30,** |   | **For the six months ended June 30,** |   |
|----------------------------------------------------------|--------|-----------------------------------------|--------|---------------------------------------|--------|
|                                                     |   | **2003**                                |   | **2002**                              |   | **2003** |   | **2002** |   |
| Net income  (loss)                                       |   | $                                       | (519   | )                                     | $      | (62 | ) | $ | (422 | ) | $ | 113 |   |
|                                                     |   |                                    |   |                                  |   |   |   |   |   |
| Other  comprehensive income, before tax, and             |   |                                    |   |                                  |   |   |   |   |   |
| unrealized  losses on securities:                        |   |                                    |   |                                  |   |   |   |   |   |
| Unrealized gain  (loss) on securities available for sale |   | (32                                     | )      | 496                                   |   | (220 | ) | 292 |   |
| Other  comprehensive income (loss), before tax           |   | (32                                     | )      | 496                                   |   | (220 | ) | 292 |   |
|                                                     |   |                                    |   |                                  |   |   |   |   |   |
| Income tax  benefit (expense) related to items of other  |   |                                    |   |                                  |   |   |   |   |   |
| comprehensive  income                                    |   | 13                                      |   | (203                                  | )      | 91 |   | (120 | ) |
| Other  comprehensive loss                                |   | (19                                     | )      | 293                                   |   | (129 | ) | 172 |   |
| Total  comprehensive income                              |   | $                                       | (538   | )                                     | $      | 231 |   | $ | (551 | ) | $ | 285 |   |

 

 

NOTE 9—JUNIORSUBORDINATED DEFERRABLE INTEREST DEBENTURES

 

         In 2001, the Company, through NationalMercantile Capital Trust I (the “Trust”), issued 15,000 of 10.25% fixed ratesecurities (the “Trust Preferred Securities”), with a liquidation amount of$1,000 per Trust Preferred Security and an aggregate liquidation amount of$15.0 million due July 25, 2031.  The Trust Preferred Securities representundivided beneficial interests in the assets of the Trust and areunconditionally guaranteed by the Company with respect to distributions andpayments upon liquidation, redemption and otherwise pursuant to the terms of aguarantee agreement.

 

         The primary assets of the Trust are$15.5 million aggregate principal amount of the Company’s 10.25% fixed ratejunior subordinated deferrable interest debentures due July 25, 2031 that payinterest each January 25 and July 25. The interest is deferrable, at the Company’s option, for a period up toten consecutive semi-annual payments, but in any event not beyond June 25,2031.  The debentures are redeemable, inwhole or in part, at the Company’s option on or after five years from issuanceat declining premiums to maturity.

 

         The costs associated with the TrustPreferred Securities issuance have been netted against the proceeds and arebeing accreted using a method that approximates the interest method over aperiod of thirty years.  The recordedbalance of Trust Preferred Securities was $14.5 million at June 30, 2003 andDecember 31, 2002.

 

11

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NOTE 10—DERIVATIVEFINANCIAL INSTRUMENTS

 

         In January 2003, the Company enteredinto a interest rate swap agreement pursuant to which it exchanged a fixed ratepayment obligation of 10.25% on a notional principal amount of $15.0 millionfor a floating rate interest based on the six-month London InterBank OfferedRate plus 458 basis points for a 29-year period ending July 25, 2031.  The interest rate swap agreement results inthe Company paying or receiving the difference between the fixed and floatingrates at specified intervals calculated based on the notional amounts.  The differential paid or received on theinterest rate swap is recognized as an adjustment to interest expense.  At July 25, 2003, the Company was paying aninterest rate of 5.70% under the terms of the swap which will reduce itsinterest expense $642,000 for the twelve months ended December 31, 2003.  The counter party to the swap has the optionto call the swap under a declining premium schedule beginning July 2006.

 

         The interest rate swap reduces theadverse impact of the Company’s 10.25% fixed rate Trust Preferred Securities ina declining interest rate environment. The Company does not utilize derivatives for speculative purposes.  Under Statement of Financial AccountingStandards No. 133 this swap transaction is designated as a fair valuehedge.  Accordingly, the ineffectiveportion of the change in the fair value of the swap transaction is recordedeach period in current income.  Theterms of the swap are symmetrical with the terms of the Trust PreferredSecurities, including the payment deferral terms, and considered highlyeffective in offsetting changes in fair value of the Trust PreferredSecurities.  Accordingly, an $269,000increase in the fair value of the swap was recorded in income for thethree-month period ended June 30, 2003 and an $456,000 increase in the fairvalue of the swap was recorded in income for the six-month period ended June30, 2003 with an offsetting charge to earnings to reflect a similar increase inthe fair value of the Trust Preferred Securities.   No ineffectiveness was recorded to current earnings related tothe interest rate swap.

 

NOTE 11—PREFERRED STOCK

 

                In the first quarter of 2003, 2,200 shares of SeriesA non-cumulative convertible perpetual preferred stock were converted to 4,400shares of common stock as reflected in the Shareholders’ equity section of theConsolidated balance sheets.

 

 

NOTE 12—RECLASSIFICATIONS

 

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

 

12

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NOTE 13—ACCOUNTINGPRONOUNCEMENTS

 

In January 2003, the FASB issued Interpretation No. 46, Consolidationof Variable Interest Entities, also known as FIN No. 46.  FIN No. 46 changes the consolidationrequirements by requiring a variable interest entity to be consolidated by acompany if that company is subject to the majority of the risk of loss from thevariable interest entity’s activities or entitled to receive a majority of theentity’s residual returns or both.  Inaddition, FIN No. 46 requires disclosures about variable interest entities thatthe company is not required to consolidate but in which it has a significant variableinterest.   The consolidationrequirements of FIN No. 46 apply to variable interest entities created afterJanuary 31, 2003 and apply to existing variable interest entities in the firstfiscal year or interim period beginning after June 15, 2003.

 

In order to comply with FIN No. 46 the Company will be required torestate consolidated balance sheets and consolidated statements of operations,to show the junior subordinated debentures as other liabilities and otherinterest expense, respectively, but it will not have a material effect on thecompany.

 

In May 2003, the FASB issued Statement of Financial AccountingStandards No. 150, Accounting for Certain Financial Instruments withCharacteristics of both Liabilities and Equity, also known as SFAS No. 150.SFAS No. 150 establishes standards for how an issuer classifies and measurescertain financial instruments with characteristics of both liabilities andequity.  It requires than an issuerclassify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many ofthose instruments were previously classified as equity.  The Adoption of SFAS No. 150 will not have amaterial effect on our earnings or financial position.

 

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

 

National Mercantile Bancorp (“National Mercantile” on a parent-onlybasis, and the ‘‘Company’’ on a consolidated basis) is the holding company fortwo subsidiary banks, Mercantile National Bank (“Mercantile”) and South BayBank, N.A. (“South Bay”) (and collectively, “the Banks”).  National Mercantile’s principal assets arethe capital stock of Mercantile and South Bay. National Mercantile Capital Trust I (the “Trust”) is a Delawarestatutory business trust formed for the exclusive purpose of issuing andselling trust preferred securities and also is a consolidated subsidiary of theCompany.

 

13

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**RESULTS OF OPERATIONS**

 

The Company recorded a net loss of $519,000, or $0.19 basic and dilutedloss per share, for the three months ended June 30, 2003 compared to a net lossof $62,000, or $0.08 basic and diluted loss per share, for the same period of2002.   The increase in net loss for the2003 period was primarily due to a $1.0 million increase in provision forcredit losses partially offset by a $106,000 decrease in the minority interestin the Company’s income of the preferred stock of South Bay and a decline inthe provision for income taxes of $355,000.

 

Net loss for the six months ended June 30, 2003 was $422,000, or $0.16basic and diluted loss per share, compared to a net income of $113,000 for thesame period of 2002.  On a per sharebasis, the results for the six months ended June 30, 2002 was $0.02 basic anddiluted loss per share, due to a $151,000 charge against income available toshareholders relating to the amortization of the discount on the preferredstock of South Bay.  The increase in netloss was primarily due to a $1.0 million increase in the provision for creditlosses and a $138,000 increase in operating expenses partially offset by a$106,000 decrease in the minority interest in the Company’s income of thepreferred stock of South Bay and a decline in the provision for income taxes of$354,000.

 

Return on average assets during the second quarter and first half of2003 was a minus 0.56% and 0.24%, respectively, compared to minus 0.07% and apositive 0.06% during the second quarter and first half of 2002, respectively.Return on average equity during the second quarter and first half of 2003 was aminus 6.58% and 2.70%, respectively, compared to a minus 0.97% and a positive0.89% during the second quarter and first half of 2002, respectively.

 

NET INTERESTINCOME

 

         Net interest income before the provisionfor credit losses for the three months ended June 30, 2003 and 2002 was $3.7million.  While net interest incomebefore the provision for credit losses was nearly unchanged for the periods,total interest income decreased $555,000 in the 2003 period, despite $9.3million greater average interest earning assets, due to a lower weightedaverage yield on interest-earning assets. The weighted average yield on earning assets was 5.34% for the quarterended June 30, 2003 compared to 6.19% for the same period in 2002 representingan 85 basis point decline.  The declinein interest income was fully offset by (i) a $367,000 decrease in interestexpense on deposits due to $4.8 million lower average balance and a 71 basispoint lower weighted average cost of interest-bearing deposits and (ii) a$55,000 decrease in interest expense on federal funds purchased and securitiessold under agreements to repurchase and (iii) a $57,000 decrease in interestexpense on other borrowings.  Theweighted average cost of interest bearing liabilities was 1.47% for the quarterended June

 

14

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30, 2003 comparedto 2.26% for the same period in 2002 representing a 79 basis pointdecline.  The lower yields and costswere due to the Federal Reserve’s reduction in target federal funds rate duringthe past several years in response to the slow economy and the related impactupon market rates of interest.

 

         Federal funds sold and securitiesavailable-for-sale averaged $41.4 million and $21.1 million, respectively, forthe three months ended June 30, 2003 compared to $29.9 million and $31.3million, respectively, for the second quarter in 2002.  The decrease in average securitiesavailable-for-sale and a $22.6 million increase in average noninterest bearingdeposits funded the increase in average federal funds sold and an $8.0 millionincrease in average loans receivable as well as a $14.9 million decrease ininterest bearing liabilities.  Therelative increase in federal funds sold and decrease in securitiesavailable-for-sale was due to a strategic decision by management based upon itsassessment of relative risks, particularly market value risk.

 

         The net yield on earning assets was4.45% for the three months ended June 30, 2003 compared to 4.68% for the sameperiod in 2002 due to a change in mix of interest earning assets to loweryielding 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.

 

         Net interest income was $7.2 millionfor the six months ended June 30, 2003 compared to $7.4 million for the sameperiod in 2002.  While net interest incomedecreased slightly for the periods, total interest income decreased $1.1million due to lower weighted average yield in interest-earning assets andlower average interest earning assets. The weighted average yield on earning assets was 5.54% for the sixmonths ended June 30, 2003 compared to 6.24% for the same period in 2002representing a decline of 70 basis points. The decline in interest income was partially offset by (i) a $688,000decrease in interest expense on deposits due to a 62 basis point lower weightedaverage cost of interest-bearing deposits and (ii) a $202,000 decrease ininterest expense on federal funds purchased and securities sold underagreements to repurchase and other borrowings. The weighted average cost of interest bearing liabilities was 1.65% forthe six months ended June 30, 2003 compared to 2.33% for the same period in2002 representing a decline of 68 basis points.  The lower yields and costs were due to the Federal Reserve’s reductionin target federal funds rate during the past several years in response to theslow economy and the related impact upon market rates of interest.

 

         Federal funds sold and securitiesavailable-for-sale averaged $28.2 million and $23.7 million, respectively, forthe six months ended June 30, 2003 compared to $30.7 million and $33.3 million,respectively, for the six months ended June 30, 2002.  The decrease in average federal funds sold and securitiesavailable-for-sale, as well as a $12.3 million increase in money market andsavings deposits, in the 2003 period compared to 2002 funded a $10.8 millionincrease in loans receivable and a

 

15

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$22.6 milliondecrease in relatively high-costing time certificates of deposit and a $7.6million decrease in other borrowings. The increase in loans receivable and decrease in securities availablefor sale reflects management’s emphasis on growth in higher yielding earningassets and its strategic decision to reduce risk exposure to securitiesavailable for sale, particularly market value risk.  The change in the mix of interest bearing liabilities – anincrease in noninterest bearing demand deposits and money market deposits and adecrease in time certificates of deposits – reflects management’s emphasis togrown business banking, principally at South Bay Bank, in order to generatelower costing transactional deposits.

 

         The net yield on interest-earningassets decreased from 4.67% to 4.52% due to an overall decline in yields oninterest earning assets, partially offset by overall declines in deposit rates,a change in deposit mix to lower costing deposits, and an increase innoninterest bearing demand deposits.

 

         Average loans receivable increased $8.0million or 3.1% for the three months ended June 30, 2003 compared to the sameperiod in 2002.  The weighted averageyield on loans receivable declined 61 basis points to 6.16% for the secondquarter 2003.  The lower yields on loansreceivable are due to the sustained decline in interest rates over the past twoyears affecting the yields on adjustable rate loans tied to rate indices aswell as the yields on newly originated fixed rate loans and existing fixed rateloans upon renewal at maturity.

 

         Securities available for sale decreased$10.2 million or 32.5% for the three months ended June 30, 2003 compared to thesame period 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 3.01%and 5.71% for the three months ended June 30, 2003 and 2002, respectively,representing a 270 basis point decline. The decline in yield was due to purchases of securities in the decliningrate environment during 2002 and to a lesser extent, adjustable rate securitiesin the portfolio.  Federal funds soldaveraged $41.4 million and yielded 1.29% during the second quarter of 2003compared to an average of $29.9 million yielding 1.73% for the same period in2002.

 

         Average loans receivable increased$10.8 million or 4.2% for the six months ended June 30, 2003 compared to thesame period in 2002.  The weightedaverage yield on loans receivable declined 68 basis points to 6.18% for the sixmonths ended June 30, 2003.  The loweryields on loans receivable are due to the sustained decline in interest ratesover the past two years affecting the yields on adjustable rate loans tied torate indices as well as the yields on newly originated fixed rate loans andexisting fixed rate loans upon renewal at maturity.  Securities available for sale decreased $9.5 million or 28.6% forthe six months ended June 30, 2003 compared to the same period in 2002, inorder to fund higher yielding loans, reduce higher cost funding sources and toreduce the exposure to a decline in market value in the event that market ratesbegin to rise.  The

 

16

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weighted averageyield on securities available for sale was 3.44% and 5.64% for the six monthsended June 30, 2003 and 2002, respectively, representing a 220 basis pointdecline for the six months ended June 30, 2003.  The decline in yield was due to purchases of securities in thedeclining rate environment during 2002 and to a lesser extent, adjustable ratesecurities in the portfolio.  Federalfunds sold averaged $28.2 million and yielded 1.26% during the six months endedJune 30, 2003 compared to an average of $30.7 million yielding 1.68% for thesame period in 2002.

 

Average total deposits increased $17.8 million or 6.0% to $313.7million during the second quarter of 2003 compared to $295.9 million during thesecond quarter of 2002.  Federal fundspurchased and securities sold under agreements to repurchase averaged $538,000and $2.8 million for the three months ended June 30, 2003 and 2002,respectively.  Average total otherborrowings decreased $7.8 million or 50.9% to $7.5 million during the quarterended June 30, 2003 compared to $15.3 million during the quarter ended June 30,2002 reflecting a planned reduction in these relatively high cost fundsprovided for by a reduction in securities available for sale.  Other borrowings included advances from theFederal Home Loan Bank and they were not renewed upon maturity.

 

Average total deposits increased $5.1 million or 1.7% to $303.0 millionduring the six months ended June 30, 2003 compared to $297.9 million during thesix months ended June 30, 2002.  Federalfunds purchased and securities sold under agreements to repurchase averaged $834,000and $3.0 million for the six months ended June 30, 2003 and 2002,respectively.  Average total otherborrowings decreased $7.6 million or 50.2% to $7.5 million during the sixmonths ended June 30, 2003 compared to $15.1 million during the six months endedJune 30, 2002 reflecting a planned reduction in these relatively high costfunds provided for by a reduction in securities available for sale.

 

         The weighted average cost of interestbearing liabilities declined 79 basis points to 1.47% during the second quarterof 2003 from 2.26% the during the second quarter of 2002.  This change was a result of a decrease inthe weighted average cost of interest bearing deposits to 1.34% during thefirst quarter of 2003 compared to 2.05% during the first 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 growth in escrow andtitle company deposits due to the strong residential real estate market andmortgage refinancing activity and secondarily due to management’s emphasis onbusiness banking at South Bay, which resulted in lower cost transaction depositaccounts.

 

         The weighted average cost of interestbearing liabilities declined 68 basis points to 1.65% during the six monthsended June 30, 2003 from 2.33% the during the six months ended June 30,2002.  This change was a result of adecrease in the weighted average cost of interest bearing deposits to 1.52%during the six months ended June 30, 2003 compared to 2.14%

 

17

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during the sixmonths ended June 30, 2002.  The declinein the weighted average cost of deposits was due to a lower volume ofhigher-costing time certificates of deposit as well as lower rates ondeposits.  The change in the compositionof deposits reflects management’s emphasis on business banking at South Bay,which resulted in lower cost transaction deposit accounts.

 

The weighted average cost of other borrowings was 4.76% during thesecond quarter of 2003 compared to 3.83% during the second quarter of2002.  The increase was due to thematurity of lower costing borrowings.

 

The weighted average cost of other borrowings was 4.79% during the sixmonths ended June 30, 2003 compared to 3.96% during the six months ended June30, 2002.  The increase was due to thematurity of lower costing borrowings

 

Average noninterest-bearing demand deposits increased $22.6 million or22.7% during the second quarter 2003 to $122.1 million from $99.5 million dueto management’s emphasis on growth in business banking.

 

Average noninterest-bearing demand deposits increased $15.4 million or15.7% during the six months ended June 30, 2003 to $113.9 million from $98.5million primarily as a result of growth in escrow and title company depositsdue to the strong residential real estate market and mortgage refinancingactivity.

 

18

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         The following table presents thecomponents of net interest income for the three months ended June 30, 2003 and2002.

 
|                                                                                                                 |   | **Three months ended**      |    |
|----------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|---------|
|                                                                                                                 |   | **June 30, 2003**           |    | **June 30, 2002** |   |
| ** **                                                                                                           |   | **Average Amount**          |    | **Interest Income/Expense** |   | **Weighted Average Yield/Rate** |   | **Average Amount** |   | **Interest Income/Expense** |   | **Weighted Average Yield/Rate** |   |
|                                                                                                                 |   | **(Dollars  in thousands)** |    |
| Assets:                                                                                                              |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Federal funds  sold and securities                                                                                   |   |                        |    |   |   |   |   |   |   |   |   |   |   |
|   purchased under agreements to resell                                                                          |   | $                           | 41,409  |   | 133 |   | 1.29 | % | $ | 29,898 |   | $ | 129 |   | 1.73 | % |
| Securities  available-for-sale                                                                                       |   | 21,147                      |    | 159 |   | 3.01 | % | 31,309 |   | 447 |   | 5.71 | % |
| Loans receivable  (1) (2)                                                                                            |   | 266,520                     |    | 4,090 |   | 6.16 | % | 258,545 |   | 4,361 |   | 6.77 | % |
| Total interest  earning assets                                                                                       |   | 329,076                     |    | 4,382 |   | 5.34 | % | 319,752 |   | 4,937 |   | 6.19 | % |
|                                                                                                                 |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Noninterest  earning assets:                                                                                         |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Cash and due  from banks - demand                                                                                    |   | 22,045                      |    |   |   |   |   | 19,477 |   |   |   |   |   |
| Other assets                                                                                                         |   | 22,537                      |    |   |   |   |   | 24,015 |   |   |   |   |   |
| Allowance for  credit losses and net unrealized gain on sales of securities  available-for-sale                      |   | (4,518                      | )       |   |   |   |   | (5,453 | ) |   |   |   |   |
| Total assets                                                                                                         |   | $                           | 369,140 |   |   |   |   |   | $ | 357,791 |   |   |   |   |   |
|                                                                                                                 |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Liabilities and  shareholders' equity:                                                                               |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  deposits:                                                                                          |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Demand                                                                                                               |   | $                           | 27,592  |   | 28 |   | 0.41 | % | $ | 27,759 |   | $ | 85 |   | 1.23 | % |
| Money market and  savings                                                                                            |   | 99,262                      |    | 254 |   | 1.03 | % | 85,104 |   | 371 |   | 1.75 | % |
| Time  certificates of deposit:                                                                                       |   |                        |    |   |   |   |   |   |   |   |   |   |   |
|   $100,000 or more                                                                                              |   | 30,643                      |    | 119 |   | 1.56 | % | 46,002 |   | 194 |   | 1.69 | % |
|   Under $100,000                                                                                                |   | 34,117                      |    | 237 |   | 2.79 | % | 37,598 |   | 355 |   | 3.79 | % |
| Total time  certificates of deposit                                                                                  |   | 64,760                      |    | 356 |   | 2.20 | % | 83,600 |   | 549 |   | 2.63 | % |
| Total  interest-bearing deposits                                                                                     |   | 191,614                     |    | 638 |   | 1.34 | % | 196,463 |   | 1,005 |   | 2.05 | % |
| Other borrowings                                                                                                     |   | 7,500                       |    | 89 |   | 4.76 | % | 15,282 |   | 146 |   | 3.83 | % |
| Federal funds  purchased and securities                                                                              |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| sold under  agreements to repurchase                                                                                 |   | 538                         |    | 3 |   | 2.24 | % | 2,758 |   | 58 |   | 8.44 | % |
| Total  interest-bearing liabilities                                                                                  |   | 199,652                     |    | 730 |   | 1.47 | % | 214,503 |   | 1,209 |   | 2.26 | % |
|                                                                                                                 |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  liabilities:                                                                                    |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Noninterest  bearing demand deposits                                                                                 |   | 122,110                     |    |   |   |   |   | 99,486 |   |   |   |   |   |
| Other  liabilities                                                                                                   |   | 1,228                       |    |   |   |   |   | 2,517 |   |   |   |   |   |
| Guaranteed  preferred beneficial interests in the Company's junior subordinated  deferrable interest debentures, net |   | 14,536                      |    |   |   |   |   | 14,520 |   |   |   |   |   |
| Minority  interest of the preferred stock of subsidiary                                                              |   | —                      |    |   |   |   |   | 788 |   |   |   |   |   |
| Shareholders'  equity                                                                                                |   | 31,614                      |    |   |   |   |   | 25,977 |   |   |   |   |   |
| Total  liabilities and shareholders' equity                                                                          |   |  $369,140              |    |   |   |   |   | $ | 357,791 |   |   |   |   |   |
|                                                                                                                 |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Net interest  income (spread)                                                                                        |   |                        |    | $ | 3,652 |   | 3.87 | % |   |   | $ | 3,728 |   | 3.93 | % |
|                                                                                                                 |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Net yield on  earning assets (2)                                                                                     |   |                        |    |   |   | 4.45 | % |   |   |   |   | 4.68 | % |
|                                                                                                                      |        |                             |         |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

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

(2) Yields and amounts earnedon loans receivable include loan fees of $227,000 and $112,000 for the threemonths ended June 30, 2003 and 2002, respectively. 

 

19

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The followingtable presents the components of net interest income for the six months endedJune 30, 2003 and 2002. 

 

**AverageBalance Sheet and**

**Analysisof Net Interest Income**

 
|                                                                                                                      |   | **Six months ended**        |    |
|---------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|---------|
|                                                                                                                      |   | **June 30, 2003**           |    | **June 30, 2002** |   |
| ** **                                                                                                                |   | **Average Amount**          |    | **Interest Income/Expense** |   | **Weighted Average Yield/Rate** |   | **Average Amount** |   | **Interest Income/Expense** |   | **Weighted Average Yield/Rate** |   |
|                                                                                                                      |   | **(Dollars  in thousands)** |    |
| Assets:                                                                                                                   |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Federal funds  sold and securities                                                                                        |   |                        |    |   |   |   |   |   |   |   |   |   |   |
|   purchased under agreements to resell                                                                               |   | $                           | 28,196  |   | 176 |   | 1.26 | % | $ | 30,655 |   | $ | 256 |   | 1.68 | % |
| Securities  available-for-sale                                                                                            |   | 23,749                      |    | 409 |   | 3.44 | % | 33,264 |   | 930 |   | 5.64 | % |
| Loans receivable  (1) (2)                                                                                                 |   | 267,911                     |    | 8,207 |   | 6.18 | % | 257,128 |   | 8,752 |   | 6.86 | % |
| Total interest  earning assets                                                                                            |   | 319,856                     |    | 8,792 |   | 5.54 | % | 321,047 |   | 9,938 |   | 6.24 | % |
|                                                                                                                      |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Noninterest  earning assets:                                                                                              |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Cash and due  from banks – demand                                                                                    |   | 21,437                      |    |   |   |   |   | 20,351 |   |   |   |   |   |
| Other assets                                                                                                              |   | 21,348                      |    |   |   |   |   | 24,139 |   |   |   |   |   |
| Allowance for  credit losses and net unrealized gain on sales of securities  available-for-sale                           |   | (4,507                      | )       |   |   |   |   | (5,924 | ) |   |   |   |   |
| Total assets                                                                                                              |   | $                           | 358,134 |   |   |   |   |   | $ | 359,613 |   |   |   |   |   |
|                                                                                                                      |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Liabilities and  shareholders’ equity:                                                                               |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  deposits:                                                                                               |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Demand                                                                                                                    |   | $                           | 27,621  |   | 89 |   | 0.65 | % | $ | 27,658 |   | $ | 157 |   | 1.14 | % |
| Money market and  savings                                                                                                 |   | 94,147                      |    | 555 |   | 1.19 | % | 81,834 |   | 699 |   | 1.72 | % |
| Time  certificates of deposit:                                                                                            |   |                        |    |   |   |   |   |   |   |   |   |   |   |
|   $100,000 or more                                                                                                   |   | 31,352                      |    | 266 |   | 1.71 | % | 48,917 |   | 501 |   | 2.07 | % |
|   Under $100,000                                                                                                     |   | 35,915                      |    | 519 |   | 2.91 | % | 40,975 |   | 760 |   | 3.74 | % |
| Total time  certificates of deposit                                                                                       |   | 67,267                      |    | 785 |   | 2.35 | % | 89,892 |   | 1,261 |   | 2.83 | % |
| Total  interest-bearing deposits                                                                                          |   | 189,035                     |    | 1,429 |   | 1.52 | % | 199,384 |   | 2,117 |   | 2.14 | % |
| Other borrowings                                                                                                          |   | 7,500                       |    | 178 |   | 4.79 | % | 15,069 |   | 296 |   | 3.96 | % |
| Federal funds  purchased and securities sold under agreements to repurchase                                               |   | 834                         |    | 11 |   | 2.66 | % | 2,952 |   | 95 |   | 6.49 | % |
| Total  interest-bearing liabilities                                                                                       |   | 197,369                     |    | 1,618 |   | 1.65 | % | 217,405 |   | 2,508 |   | 2.33 | % |
|                                                                                                                      |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  liabilities:                                                                                         |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Noninterest  bearing demand deposits                                                                                      |   | 113,942                     |    |   |   |   |   | 98,507 |   |   |   |   |   |
| Other  liabilities                                                                                                        |   | 803                         |    |   |   |   |   | 2,868 |   |   |   |   |   |
| Guaranteed  preferred beneficial interests in the Company’s junior subordinated  deferrable interest debentures, net |   | 14,534                      |    |   |   |   |   | — |   |   |   |   |   |
| Minority  interest of the preferred stock of subsidiary                                                                   |   | —                      |    |   |   |   |   | 752 |   |   |   |   |   |
| Shareholders’  equity                                                                                                |   | 31,486                      |    |   |   |   |   | 25,563 |   |   |   |   |   |
| Total  liabilities and shareholders’ equity                                                                          |   | $                           | 358,134 |   |   |   |   |   | $ | 345,095 |   |   |   |   |   |
|                                                                                                                      |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Net interest  income (spread)                                                                                             |   |                        |    | $ | 7,174 |   | 3.89 | % |   |   | $ | 7,430 |   | 3.92 | % |
|                                                                                                                      |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Net yield on  earning assets (2)                                                                                          |   |                        |    |   |   | 4.52 | % |   |   |   |   | 4.67 | % |
|                                                                                                                           |        |                             |         |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

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

(2) Yields and amounts earnedon loans receivable include loan fees of $417,000 and $279,000 for the six monthsended June 30, 2003 and 2002, respectively. 

 

20

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

 

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

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

 
| ** **                                                                  |   | **Six months ended June 30,  2003 vs 2002** |   |
|-----------------------------------------------------------------------------|--------|---------------------------------------------|--------|
| ** **                                                                  |   | **Increase (decrease)   due to:**      |   | **Net Increase** |   |
|                                                                        |   | **Volume**                                  |   | **Rate** |   | **(Decrease)** |   |
| Interest Income:                                                            |   |                                        |   |   |   |   |   |
| Federal funds  sold and securities purchased under agreement to resell      |   | $                                           | (20    | ) | $ | (60 | ) | $ | (80 | ) |
| Securities  available-for-sale                                              |   | (268                                        | )      | (253 | ) | (521 | ) |
| Loans receivable  (2)                                                       |   | 367                                         |   | (912 | ) | (545 | ) |
| Total  interest-earning assets                                              |   | 79                                          |   | (1,225 | ) | (1,146 | ) |
|                                                                        |   |                                        |   |   |   |   |   |
| Interest  Expense:                                                          |   |                                        |   |   |   |   |   |
| Interest-bearing  deposits:                                                 |   |                                        |   |   |   |   |   |
| Demand                                                                      |   | $                                           | — |   | $ | (68 | ) | $ | (68 | )  |
| Money market and  savings                                                   |   | 105                                         |   | (249 | ) | (144 | ) |
| Time  certificates of deposit:                                              |   |                                        |   |   |   |   |   |
|   $100,000 or more                                                     |   | (180                                        | )      | (55 | ) | (235 | ) |
|   Under $100,000                                                       |   | (94                                         | )      | (147 | ) | (241 | ) |
| Total time  certificates of deposit                                         |   | (274                                        | )      | (202 | ) | (476 | ) |
| Total  interest-bearing deposits                                            |   | (169                                        | )      | (519 | ) | (688 | ) |
| Other borrowings                                                            |   | (149                                        | )      | 31 |   | (118 | ) |
| Federal funds  purchased and securities sold under agreements to repurchase |   | (68                                         | )      | (16 | ) | (84 | ) |
| Total  interest-bearing liabilities                                         |   | (385                                        | )      | (504 | ) | (890 | ) |
|                                                                        |   |                                        |   |   |   |   |   |
| Net interest  income                                                        |   | $                                           | 465    |   | $ | (721 | ) | $ | (256 | )  |
|                                                                             |        |                                             |        |  |  |  |  |  |  |  |  |

 

----

(1)The change in interest income or interest expense that is attributable to bothchanges in average balance and average rate has been allocated to the changesdue to (i) average balance and (ii) average rate in proportion to therelationship of the absolute amounts of changes in each.

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

 

PROVISION FORCREDIT LOSSES

 

Provision for credit losses for the three months and six months endedJune 30, 2003 was $1.1 million and $1.3 million, respectively, compared to$150,000 and $300,000 for the three months and six months ended June 30, 2002,respectively.   The increase inprovisions for credit losses during the second quarter 2003 was requiredfollowing the charge off and write down

 

21

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of severalnonperforming loans.  Loan charge-offsduring the second quarter of 2003 were $2.4 million compared to $401,000 duringthe second quarter of 2002.  Loancharge-offs during the six months ended June 30, 2003 were $2.8 millioncompared to $1.8 million during the six months ended June 30, 2002.  Recoveries were $54,000 during the secondquarter of 2003, compared to $176,000 during the second quarter of 2002.Recoveries were $194,000 during the six months ended June 30, 2003 compared to$336,000 during the six months ended June 30, 2002.

 

OTHER OPERATINGINCOME

 

Other operating income decreased slightly to $284,000 during the secondquarter of 2003 from $286,000 during the second quarter of 2002 due to a losson sale of Other Real Estate Owned, offset by an increase in deposit-relatedand other customer services.

 

Other operating income increased to $719,000 during the six monthsended June 30, 2003 from $682,000 during the six months ended June 30, 2002 dueto net gains on sales of securities of $100,000 for the 2003 period compared tono gains for the 2002 period, offset by a loss on sale of Other Real EstateOwned.

 

Net gains on sales of investment securities are generated primarily indeclining interest rate environments. Accordingly, gains or losses from salesof investment securities may fluctuate significantly from period to period, andthe results in any period are not necessarily indicative of the results, whichmay be obtained in future periods.

 

OTHER OPERATING EXPENSES

 

Otheroperating expense remained stable at $3.4 million for the three months endedJune 30, 2003 and 2002. Variances within operating expenses were reflected asfollows; (i) salaries and related benefits expense increased $77,000, or 4.4%;(ii) client services expense decreased $113,000 or 44.3%; (iii) legal servicesexpense decreased $89,000 or 43.2%; (iv) other professional services expensedecreased $61,000, or 25.1%; (v) amortization of core deposit intangble expenseincreased $56,000;  and (vi) promotionand other expenses increased $178,000 or 414.0%.

 

Otheroperating expense increased by $138,000 to $6.8 million during the six monthsended June 30, 2003 compared to $6.7 million during six months ended June 30,2002.  This increase was reflected asfollows; (i) salaries and related benefits expense increased $265,000, or 7.8%;(ii) net occupancy expense decreased $49,000 or 6.8%; (iii) printing andcommunications expense decreased $49,000 or 15.8%; (iv) client services expensedecreased $126,000, or 28.3%; (v) computer data processing expense decreased$47,000, or 9.2%;  (vi) legal servicesexpense decreased $120,000, or 31.6%; (vii)

 

22

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other professionalservices expense increased $90,000 or 28.4%; and (viii) amortization of coredeposits expenses increased $112,000.

 

Theincrease in salary and related expense in the second quarter of 2003  is due to greater temporary help expense andan increase in incentive bonus accrual. The temporary help expense is expected to decrease in later quarters,however, it will be largely offset by salary expense.  The decline in client services is primarily related to thedecrease in services by the escrow customers. The decline in legal expense forthe 2003 period reflects lower expenses for credit collection. Otherprofessional expense decreased for the three months ended June 30, 2003 to$182,000 from $243,000 during the second quarter of 2002.  This decrease is due to the consultingexpense and a nonrecurring expense related to the sale of nonperforming assetsat South Bay in the second quarter of 2002.

 

MINORITY INTERESTIN THE COMPANY’S INCOME

 

The minority interest of the guaranteed beneficial interest in theCompany’s junior subordinated deferrable interest debentures (“Trust PreferredSecurities”) in the Company’s income was $223,000 and $389,000 for the threemonths ended June 30 , 2003 and 2002, respectively, representing the interestexpense of the Trust Preferred Securities that are classified as mezzanineequity for accounting purposes.

 

         The decline in interest expense of theTrust Preferred Securities is due to an interest rate swap agreement that the Companyentered 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 was 6.18% and 10.25% for the three months ended March 31,2003 and 2002, respectively. On July 25, 2003 the interest rate reset and theCompany was paying an interest rate of 5.93% under the terms of the swap.

 

         This swap transaction is designated asa fair value hedge.  Accordingly, an$269,000 increase in the fair value of the swap was recorded in income for thethree-month period ended June 30, 2003. The terms of the swap are symmetrical with the terms of the TrustPreferred Securities, including the payment deferral terms, and consideredhighly effective in offsetting changes in fair value of the Trust PreferredSecurities.  Accordingly, an offsettingcharge to earnings was recorded for the three months ended June 30, 2003 toreflect the increase in the fair value of the Trust Preferred Securities.

 

23

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***BALANCE SHEET ANALYSIS***

 

 

INVESTMENT SECURITIES

 

The following comparativeperiod-end table sets forth certain information concerning the estimated fairvalues and unrealized gains and losses of available-for-sale securities.

 

**Estimated Fair Values of andUnrealized**

**Gains and Losses on InvestmentSecurities**

 
|                                                                      |   | **June 30, 2003**             |         |
|---------------------------------------------------------------------------|--------|-------------------------------|--------------|
| ** **                                                                |   | **Total amortized**

**cost** |         | **Gross unrealized gains** |   | **Gross unrealized loss** |   | **Estimated fair value** |   |
|                                                                      |   | **(Dollars in thousands)**    |         |
| U.S. Treasury  securities                                                 |   | $                             | 3,746        |   | $ | — |   | $ | 1 |   | $ | 3,745 |   |
| GNMA-issued/guaranteed  mortgage pass through certificates                |   | 583                           |         | 14 |   | — |   | 597 |   |
| FHLMC/FNMA-issued  mortgage pass through certificates                     |   | 7,568                         |         | 269 |   | — |   | 7,837 |   |
| CMO’s and  REMIC’s issued by U.S. government-sponsored agencies |   | 1,109                         |         | — |   | 3 |   | 1,106 |   |
| Mutual Funds                                                              |   | 5,000                         |         | — |   | 5 |   | 4,995 |   |
| Privately issued  corporate bonds, CMO and REMIC securities               |   | 3,542                         |         | 9 |   | 157 |   | 3,394 |   |
|                                                                      |   | $                             |  21,548 |   | $ |  292 |   | $ |  166 |   | $ |  21,674 |   |
|                                                                      |   |                          |         |   |   |   |   |   |   |
| FRB and other  equity stocks                                              |   | $                             | 1,867        |   | — |   | — |   | $ | 1,867 |   |

 
|                                                                      |   | **December 31, 2002**         |         |
|---------------------------------------------------------------------------|--------|-------------------------------|--------------|
| ** **                                                                |   | **Total amortized**

**cost** |         | **Gross unrealized gains** |   | **Gross unrealized loss** |   | **Estimated fair value** |   |
|                                                                      |   | **(Dollars in thousands)**    |         |
| 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 |   |

 

24

----

 

The total amortized costof investment securities decreased $4.3 million to $21.5 million at June 30,2003 from $25.8 million at December 31, 2002 due to maturities, repayments orpaydowns on principal amortizing securities and the sale of $2.6 million ofsecurities.  The Company had a netunrealized gain of $126,000 at June 30, 2003 on its investment securitiesportfolio compared to a net unrealized gain of $346,000 at December 31, 2002.

 

As of June 30, 2003 theCompany did not hold securities of any issuer, other than U.S. governmentagencies and corporations, the aggregate book value of which exceeded 10% ofthe Company’s shareholders’ equity.

 

Gross realized gains onsale of securities available-for sale were $100,000 for the six months endedJune 30, 2003 and there were no realized gains on the sale of securitiesfor  the six months ended June 30, 2002.

 

LOAN PORTFOLIO

 

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

 

 

**LoanPortfolio Composition**

** **
| ** **                                                            |   | **June 30, 2003**          |    | **December 31, 2002** |   |
|-----------------------------------------------------------------------|--------|----------------------------|---------|-----------------------|--------|
|                                                                  |   | **Amount**                 |    | **Percent**           |   | **Amount** |   | **Percent** |   |
|                                                                  |   | **(Dollars in thousands)** |    |
| Commercial  loans:                                                    |   |                       |    |                  |   |   |   |   |   |
| Secured by one  to four family residential properties                 |   | $                          | 9,420   |                  | 4      | % | $ | 10,797 |   | 4 | % |
| Secured by  multifamily residential properties                        |   | 13,493                     |    | 5                     | %      | 12,596 |   | 5 | % |
| Secured by  commercial real properties                                |   | 123,407                    |    | 46                    | %      | 119,872 |   | 44 | % |
| Other – secured  and unsecured                                   |   | 82,252                     |    | 31                    | %      | 86,015 |   | 32 | % |
| Real estate  construction and land development                        |   | 35,902                     |    | 14                    | %      | 37,934 |   | 14 | % |
| Consumer  installment, home equity and unsecured loans to individuals |   | 2,204                      |    | 1                     | %      | 5,566 |   | 1 | % |
| Total loans  outstanding                                              |   | 266,678                    |    | 100                   | %      | 272,780 |   | 100 | % |
|                                                                  |   |                       |    |                  |   |   |   |   |   |
| Deferred net  loan origination  fees and purchased loan discount      |   | (528                       | )       |                  |   | (457 | ) |   |   |
| Loans  receivable, net                                                |   | $                          | 266,150 |                  |   |   | $ | 272,323 |   |   |   |

 

25

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       Total loans outstandingdecreased by $6.1 million to $266.7 million at June 30, 2003 compared to $272.8million at December 31, 2002 as loan payoffs exceeded loan originations andloans charge offs.  The Companyexperienced a higher volume of loan originations than payoffs and prior year’sorigination volume in its commercial real estate loans and loans secured bymultifamily residential properties during the first six months of 2003resulting in an increase from December 31, 2002.  These increases were more than offset by decreases in othersecured and unsecured commercial loans, consumer installment loans and realestate construction and land development loans.

 

NONPERFORMING ASSETS

 

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

 

**NonperformingAssets**

 
| ** **                                                                                                                  |   | **June 30, 2003**          |   | **December 31 2002** |   |
|-----------------------------------------------------------------------------------------------------------------------------|--------|----------------------------|--------|----------------------|--------|
|                                                                                                                        |   | **(Dollars in thousands)** |   |
| Nonaccrual loans                                                                                                            |   | $                          | 592    |                 | $      | 5,787 |   |
| Troubled debt  restructurings                                                                                               |   | —                     |   | —               |   |
| Loans  contractually past due ninety or more days with respect to either principal  or interest and still accruing interest |   | 9                          |   | 209                  |   |
| Nonperforming  loans                                                                                                        |   | 601                        |   | 5,996                |   |
| Other real  estate owned                                                                                                    |   | 1,000                      |   | 1,000                |   |
| Other  nonperforming assets                                                                                                 |   | —                     |   | —               |   |
| Total  nonperforming assets                                                                                                 |   | $                          | 1,601  |                 | $      | 6,996 |   |
|                                                                                                                        |   |                       |   |                 |   |
| Allowance for  credit losses as a percent of nonaccrual loans                                                               |   | 583.1                      | %      | 83.7                 | %      |
| Allowance for  credit losses as a percent of nonperforming loans                                                            |   | 574.4                      | %      | 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                                                      |   | 5.2                        | %      | 22.4                 | %      |

 

       Nonaccrual loans decreased$5.2 million at June 30, 2003 to $592,000 million from $5.8 million at December31, 2002 due primarily to collection of nonaccrual loans and loan charge offs.There were $9,000 of loans past due 90 days or more and still accruing interestat June 30, 2003 compared to $209,000 at December 31, 2002.  As a result, the amount of nonperformingassets at June 30, 2003 decreased 77.1% from the level at December 31, 2002.

 

26

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ALLOWANCE FOR CREDITLOSSES

 

Provisions for credit losses charged to operations reflect management’sjudgment of the adequacy of the allowance for credit losses and are determinedthrough periodic analysis of the loan portfolio.  This analysis includes a detailed review of the classificationand categorization of problem loans and loans to be charged off; an assessmentof the overall quality and collectibility of the portfolio; and considerationof the loan loss experience, trends in problem loan concentrations of creditrisk, as well as current and expected future economic conditions (particularlySouthern California). Management, in conjunction****withan outside advisory firm, performs a periodic risk and credit analysis, theresults of which are reported to the Board of Directors.

 

Loans charged off during the second quarter and first half of 2003 were$2.4 million and $2.8 million, respectively, compared to $401,000 and $1.8million during the second quarter and first half of 2002, respectively.  Recoveries of loans previously charged offwere $54,000 and $194,000 during the second quarter and first half of 2003compared to $176,000 and $336,000 during the second quarter and first half of2002, respectively.  See Note 4 of Notesto Consolidated Financial Statements.

 

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

 

TOTAL DEPOSITS

 

Total deposits were $312.0 million and $298.7 million at June 30, 2003and December 31, 2002, respectively. Noninterest-bearing demand deposits and money market deposits were$123.6 million and $51.3 million, respectively, at June 30, 2003 compared to$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 and an increase in deposits from the Company’s escrow customers.  Interest-bearing demand deposits, which arelargely limited to individuals, decreased to $27.6 million at June 30, 2003from $30.5 million at December 31, 2002. Savings deposits increased to $46.8 million at June 30, 2003 compared to$42.2 million at December 31, 2002 reflecting the relatively

 

27

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higher yieldsbeing paid on this deposit type.  Timecertificates of deposit (“TCDs”) decreased significantly to $62.7 million atJune 30, 2003 from $75.4 million at December 31, 2002.  This decrease is due to an emphasis ongrowing lower cost deposit accounts. Additionally, TCDs $100,000 and overdecreased due to the termination of a $15.0 million public funds depositpartially offset by $5.0 million of brokered TCDs in January, 2003.  There were no brokered TCDs at December 31,2002.

 

FEDERAL FUNDS SOLD AND SECURITIES SOLD UNDERAGREEMENTS TO REPURCHASE

 

Federal funds sold and securities sold under agreements to repurchaseat June 30, 2003 were $395,000 compared to $1.5 million at year-end 2002.   The decline is due to the planned runoff ofthe higher costing liabilities at South Bay.

 

 

OTHER BORROWINGS

 

**        **Otherborrowings were $7.5 million at June 30, 2003 and December 31, 2002representing advances from the Federal Home Loan Bank.

 

SHAREHOLDERS’ EQUITY

 

Shareholders’ equity declined from $31.2 at December 31, 2002 to $30.7million at June 30, 2003 due to the net loss for the six months ended June 30,2003 and the declines in market value of securities available-for-sale.

 

 

***CAPITAL ADEQUACY REQUIREMENTS***

 

         At June 30, 2003 the Company and theBanks were in compliance with all applicable regulatory capital requirementsand the Banks were “well capitalized” under the Prompt Corrective Action rulesof the OCC.  The following table setsforth the regulatory capital standards for well capitalized institutions, andthe capital ratios for the Company and the Banks as of June 30, 2003 andDecember 31, 2002.

 

28

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**RegulatoryCapital Information**

**ofthe National MercantileBancorp and Banks**

 
| ** **                        |   | **Minimum For Capital Adequacy Purposes** |   | **Well Capitalized Standards** |   | **June 30, 2003** |   | **December 31, 2002** |   |
|-----------------------------------|--------|-------------------------------------------|--------|--------------------------------|--------|-------------------|--------|-----------------------|--------|
| **National  Mercantile Bancorp:** |   |                                      |   |                           |   |              |   |                  |   |
| Tier 1 leverage                   |   | 4.00                                      | %      | N/A                            |   | 8.32              | %      | 8.60                  | %      |
| Tier 1 risk-based  capital        |   | 4.00                                      | %      | N/A                            |   | 10.33             | %      | 10.57                 | %      |
| Total risk-based  capital         |   | 8.00                                      | %      | N/A                            |   | 13.03             | %      | 13.31                 | %      |
|                              |   |                                      |   |                           |   |              |   |                  |   |
| **Mercantile  National Bank:**    |   |                                      |   |                           |   |              |   |                  |   |
| Tier 1 leverage                   |   | 4.00                                      | %      | 5.00                           | %      | 7.51              | %      | 7.20                  | %      |
| Tier 1  risk-based capital        |   | 4.00                                      | %      | 6.00                           | %      | 10.63             | %      | 9.89                  | %      |
| Total risk-based  capital         |   | 8.00                                      | %      | 10.00                          | %      | 11.88             | %      | 11.15                 | %      |
|                              |   |                                      |   |                           |   |              |   |                  |   |
| **South  Bay Bank, NA:**          |   |                                      |   |                           |   |              |   |                  |   |
| Tier 1 leverage                   |   | 4.00                                      | %      | 5.00                           | %      | 9.06              | %      | 9.38                  | %      |
| Tier 1  risk-based capital        |   | 4.00                                      | %      | 6.00                           | %      | 9.92              | %      | 10.90                 | %      |
| Total risk-based  capital         |   | 8.00                                      | %      | 10.00                          | %      | 10.88             | %      | 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.

 

         National Mercantile is a legal entityseparate and distinct from the Banks, and therefore it must provide for its ownliquidity.  National Mercantile’sprincipal sources of funds are proceeds from the sales of securities anddividends or capital distributions from the Banks.  In addition to its own operating expenses, National Mercantile isresponsible for the payment of the interest on the outstanding issues of TrustPreferred Securities.  The semi-annualinterest payments on the Trust Preferred Securities, 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.

 

Cash and due from banks was $18.6 million on June 30,2003 compared to $18.9 million on December 31, 2002.  Federal funds sold were $39.9 million and $18.7 million for June30, 2003 and December 31, 2002, respectively. Mercantile National Bank had $5.0 million and South Bay Bank had $12.0million in Federal funds lines with correspondent banks as of June 30, 2003.

 

29

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The payment of dividends by National Mercantile islimited by the terms of the Trust Preferred Securities indenture.  National Mercantile may not declare or payany dividends or other distributions on its common stock or preferred stock ifit is in default under the terms of the indenture or if it has elected to deferpayments of interest on the Trust Preferred Securities.

 

***ASSET LIABILITY MANAGEMENT***

 

The following table shows that the Company’s cumulative one-yearinterest rate sensitivity gap indicated an asset sensitive position of $80.3million at June 30, 2003, a change from an asset sensitive position of $41.2 millionat December 31, 2002.  This changeresulted primarily from an increase in assets repricing in less than threemonths, consisting of federal funds sold and adjustable rate loans receivablepartially offset by a decrease in securities available for sale.  Rate-sensitive liabilities increased only$866,000, consisting of an increase in demand, money market and savings andother borrowings, offset by a decrease in time certificates of deposit.

 

 The Company’s asset sensitiveposition during a period of slowly declining interest rates is not expected tohave a significant negative impact on net interest income since rates paid onthe Company’s large base of interest bearing demand, savings and money marketdeposit accounts historically have not changed proportionately with changes ininterest rates.  However, since theCompany is in an asset sensitive position, in a period of rapidly decliningrates, such as the environment that was experienced during 2001 and 2002, therapid decline will have a negative effect on the Company’s net interest incomeas changes in the rates of interest bearing deposits historically have notchanged in similar magnitude to changes in market interest rates.  Additionally, in relatively low anddeclining interest rate environments, the interest rates paid on fundingliabilities may begin to reach floors preventing further downward adjustmentswhile rates on earning assets continue to adjust downward.

 

30

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**Rate-SensitiveAssets and Liabilities**

 
|                                                                     |   | **June 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  |   | $                            | 39,900  |   | $ | — |   | $ | — |   | $ | — |   | $ | 39,900 |   |
| Securities  available-for-sale, at amortized cost                        |   | 12,134                       |    | 1,064 |   | 2,293 |   | 6,183 |   | 21,674 |   |
| Due from banks -  time                                                   |   | —                       |    | 325 |   | — |   | — |   |   |   |
| FRB and other stock,  at cost                                            |   | —                       |    | — |   | — |   | 1,866 |   |   |   |
| Loans receivable  (1)                                                    |   | 206,323                      |    | 7,449 |   | 16,976 |   | 35,402 |   | 266,150 |   |
| Total  rate-sensitive assets                                             |   | 258,357                      |    | 8,838 |   | 19,269 |   | 43,451 |   | 329,915 |   |
|                                                                     |   |                         |    |   |   |   |   |   |   |   |   |
| Rate-Sensitive  Liabilities: (2)                                         |   |                         |    |   |   |   |   |   |   |   |   |
| Interest bearing  deposits:                                              |   |                         |    |   |   |   |   |   |   |   |   |
| Demand, money  market and savings                                        |   | 125,699                      |    | — |   | — |   | — |   | 125,699 |   |
| Time  certificates of deposit                                            |   | 26,999                       |    | 29,277 |   | 5,749 |   | 658 |   | 62,683 |   |
| Other borrowings                                                         |   | —                       |    | 4,895 |   | 3,000 |   | — |   | 7,895 |   |
| Total  rate-sensitive liabilities                                        |   | 152,698                      |    | 34,172 |   | 8,749 |   | 658 |   | 196,277 |   |
| Interest  rate-sensitivity gap                                           |   | 105,659                      |    | (25,334 | ) | 10,520 |   | 42,793 |   | 133,638 |   |
| Cumulative  interest rate-sensitivity gap                                |   | $                            | 105,659 |   | $ | 80,325 |   | $ | 90,845 |   | $ | 133,638 |   |   |   |
| Cumulative ratio  of rate sensitive assets to rate-sensitive liabilities |   | 169                          | %       | 143 | % | 146 | % | 168 | % |   |   |
|                                                                          |        |                              |         |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1) Loans receivable excludesnonaccrual loans. 

(2) Deposits which aresubject to immediate withdrawal are presented as repricing within three monthsor less.

The distribution of othertime deposits is based on scheduled maturities.

 

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**Rate-Sensitive Asets and Liabilities**

 
|                                                                     |   | **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 aresubject to immediate withdrawal are presented as repricing within three monthsor less. The distribution of other time deposits is based on scheduledmaturities.

 

 

In October 2002,  Mercantileexecuted an informal non-binding memorandum of understanding (“MOU”),  with the OCC relating to its interest raterisk management.  The MOU provides forMercantile to take certain actions that the OCC believes 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’s  interest rate risk measurement processes byFebruary 28, 2003.  Mercantile hascompleted the actions provided in the MOU and has been informed by the OCC thatthe MOU will be terminated.

 

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# **FACTORS WHICH MAYAFFECT FUTURE OPERATING RESULTS**

 

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

 

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

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

 

•                  Ourability to originate loans;

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

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

•                  Theaverage life of our interest-earning assets;

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

•                  Ourability to access the wholesale funding market.

 

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

 

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

 

        Our financial conditiondepends significantly on the quality of our assets.  While we have developed and implemented underwriting policies andprocedures to guide us in the making of loans, compliance with these policiesand procedures in making loans does not guarantee repayment of the loans.  If the level of our non-performing assetsrises, our results of operations and financial condition will be affected.  A borrower’s ability to pay its loan inaccordance with its terms can be adversely affected by a number of factors,such as a decrease in the borrower’s revenues and cash flows due to adversechanges in economic conditions or a decline in the demand for the borrower’sproducts and/or services.

 

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

 

        We establish allowances for credit lossesagainst each segment of our loan portfolio. At June 30, 2003, our allowance for credit losses equaled 1.3% of loansreceivable and 574.4% of nonperforming loans. Although we believed that we had established adequate allowances forcredit losses as of June 30, 2003, the credit quality of our assets is affectedby many factors beyond our control, including local and national economicconditions, and the possible existence of facts which are not

 

33

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known to us whichadversely affect the likelihood of repayment of various loans in our loanportfolio and realization of the collateral upon a default.  Accordingly, we can give no assurance thatwe will not sustain loan losses materially in excess of the allowance forcredit losses.  In addition, the Officeof the Comptroller of the Currency, as an integral part of its examinationprocess, periodically reviews our allowance for credit losses and could requireadditional provisions for credit losses. Material future additions to the allowance for credit losses may also benecessary due to increases in the size and changes in the composition of ourloan portfolio.  Increases in ourprovisions for credit losses would adversely affect our results of operations.

 

 **Economic conditions may worsen.**

 

         Our business is strongly influencedby economic conditions in our market area (principally, the Greater Los Angelesmetropolitan area) as well as regional and national economic conditions and inour niche markets, including the entertainment industry in SouthernCalifornia.  During the past severalyears economic conditions in these areas have been generally unfavorable.  Should the economic condition in these areascontinue to be unfavorable, the financial condition of our borrowers couldweaken, which could lead to higher levels of loan defaults or a decline in thevalue of collateral for our loans.  Inaddition, an unfavorable economy could reduce the demand for our loans andother products and services.

 

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

 

      At June 30, 2003, a large majority ofour loans outstanding were collateralized by real properties located inCalifornia.  Because of thisconcentration in California, our financial position and results of operationshave been and are expected to continue to be influenced by general trends in theCalifornia economy and its real estate market. Real estate market declines may adversely affect the values of theproperties collateralizing loans.  Ifthe principal balances of our loans, together with any primary financing on themortgaged properties, equal or exceed the value of the mortgaged properties, wecould incur higher losses on sales of properties collateralizing foreclosedloans.  In addition, Californiahistorically has been vulnerable to certain natural disaster risks, such asearthquakes and erosion-caused mudslides, which are not typically covered bythe standard hazard insurance policies maintained by borrowers.  Uninsured disasters may adversely impact ourability to recover losses on properties affected by such disasters andadversely impact our results of operations.

 

**Our business is very competitive.**

 

       There is intensecompetition in Southern California and elsewhere in the United States forbanking customers.  We experiencecompetition for deposits from many sources, including credit unions, insurancecompanies and money market and other mutual funds, as well as other commercialbanks and savings institutions.  Wecompete for loans and deposits primarily

 

34

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with other commercial banks, mortgage companies, commercial financecompanies and savings institutions.  Inrecent years out-of-state financial institutions have entered the Californiamarket, which has also increased competition. Many of our competitors have greater financial strength, marketingcapability and name recognition than we do, and operate on a statewide ornationwide basis.  In addition, recentdevelopments in technology and mass marketing have permitted larger companiesto market loans more aggressively to our small business customers.  Such advantages may give our competitorsopportunities to realize greater efficiencies and economies of scale than wecan.  We can provide no assurance thatwe will be able to compete effectively against our competition.

 

**Our business is heavily regulated.**

 

       Both National Mercantile as a bankholding company, and Mercantile and South Bay, as national banks, are subjectto significant governmental supervision and regulation, which is intendedprimarily for the protection of depositors. Statutes and regulations affecting us may be changed at any time, andthe interpretation of these statutes and regulations by examining authoritiesalso may change.  We cannot assure youthat future changes in applicable statutes and regulations or in theirinterpretation will not adversely affect our business.

 

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

 

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

 

We recordedgoodwill of $2.2 million in connection with the South Bay acquisition inDecember 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.**

 

         In conjunction with the acquisition ofSouth Bay, we reversed our valuation allowance of $6.9 million on the deferredtax asset with the related benefit reducing goodwill.  On a periodic basis, at least annually, we perform an analysis todetermine if

 

35

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it is more likelythan not that some or all of the gross deferred tax asset will not berealized.  Factors used in the analysisthat are reflective of the future realization of a deferred tax asset are:

 

•                  A relatively consistent strong earningshistory;

•                  Future earnings are assured;

•                  Expected adequate future taxable incomearising from the reversal of temporary differences to realize the tax asset;

 

An evaluationallowance may be established to reduce the deferred tax asset to its realizablevalue.  The determination of whether avaluation allowance is necessary involves considering the positive and negativefactors related to whether the deferred tax asset is more likely than not to berealized.  Any adjustment required 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. CONTROLSAND PROCEDURES***

 

The Company’smanagement, with the participation of the Chief Executive Officer and ChiefFinancial Officer, has conducted an evaluation of the effectiveness of theCompany’s disclosure controls and procedures pursuant to Rule 13a-14 under theSecurities 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 nochange in the Company’s internal control over financial reporting during theCompany’s most recently completed fiscal quarter that has materially affected,or is reasonabley likely to materially affect, the Company’s internal controlover financial reporting.

 

36

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**PART II—OTHER INFORMATION**

 

***Item 1.       LEGAL PROCEEDINGS***

 

None.

 

***Item 2.       CHANGESIN SECURITIES***

 

None.

 

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

 

None.

 

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

*** ***

(a)           On  May 29,2003, the Company held its annual meeting of shareholders.

 

(b)          At the annual meting, the following directors wereelected:  Donald E. Benson, Joseph N.Cohen, Robert E. Gibson, Antoinette Hubenette, M.D., Scott A. Montgomery, DionG. Morrow, Carl R. Terzian and Robert E. Thomson.

 

(c)           The Following proposals were considered at the annualmeeting and the number of shares voting for or against such proposals are listedbelow.

 

Election of Directors

 
| **Name**                    |   | **Votes For** |   | **Votes  Withheld** |   |
|-----------------------------|--------|---------------|--------|---------------------|--------|
| Donald E. Benson            |   | 3,732,540     |   | 28,998              |   |
|                        |   |          |   |                |   |
| Joseph N. Cohen             |   | 3,732,540     |   | 28,998              |   |
|                        |   |          |   |                |   |
| Robert E. Gipson            |   | 3,732,540     |   | 28,998              |   |
|                        |   |          |   |                |   |
| Antoinette  Hubenette, M.D. |   | 3,732,540     |   | 28,998              |   |
|                        |   |          |   |                |   |
| Scott A.  Montgomery        |   | 3,732,540     |   | 28,998              |   |
|                        |   |          |   |                |   |
| Dion G. Morrow              |   | 3,732,540     |   | 28,998              |   |
|                        |   |          |   |                |   |
| Carl R. Terzian             |   | 3,732,540     |   | 28,998              |   |
|                        |   |          |   |                |   |
| Robert E.  Thomson          |   | 3,732,540     |   | 28,998              |   |

 

 

Amendments to the 1996 Stock Incentive Plan to increasethe number of shares available for grant by 120,000 shares increasing thenumber of option shares from 548,510 to 668,510.

 
| **Votes For** |   | **Votes  Against** |   | **Abstentions** |   | **Broker  Non-votes** |   |
|---------------|--------|--------------------|--------|-----------------|--------|-----------------------|--------|
| 2,893,018     |   | 172,721            |   | 4,242           |   | 691,557               |   |

 

37

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Amendments to Article XIII of the Articles ofIncorporation to extend the termination date for Article XIII (which imposes ashare transfer restriction) from July 1, 2003 to July 1, 2006.

 
| **Votes For** |   | **Votes  Against** |   | **Abstentions** |   | **Broker  Non-votes** |   |
|---------------|--------|--------------------|--------|-----------------|--------|-----------------------|--------|
| 3,001,097     |   | 64,316             |   | 4,568           |   | 691,557               |   |

 

***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 ofthe Sarbanes-Oxley Act of 2002

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

 

(b) *Reports on Form 8-K.*

 

         Form 8-K, reporting the Company’s press release regardingsecond quarter 2003 operating results was filed August 8, 2003.

 

**SIGNATURES**

 

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

 
|                         |   | **NATIONAL MERCANTILE BANCORP**                       |
|------------------------------|--------|-------------------------------------------------------|
|                         |   | (Registrant)                                          |
|                         |   |                                                  |
| DATE:  August  14, 2003 |   |  /s/Scott A. Montgomery                          |
|                         |   | **Scott  A. Montgomery**                              |
|                         |   | Chief Executive Officer                               |
|                         |   |                                                  |
| DATE:  August  14, 2003 |   |  /s/David R. Brown                               |
|                         |   | **David  R. Brown**                                   |
|                         |   | Principal Financial and  Principal Accounting Officer |

 

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