**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**Form 10-QSB**

 

ý  **Quarterlyreport under section 13 or 15(d) of the Securities Exchange Act of 1934**

**for the quarterly period endedJune 30, 2004**

 

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

**for the transition period from       to       **

 

**CommissionFile Number 0-15982**

 

**NATIONALMERCANTILE BANCORP**

(Exact name of small business issuer in its charter)

 

| **California**                                                                |   | **95-3819685**                        |
|-------------------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization)              |   | (I.R.S. Employer  Identification No.) |
|                                                                          |   |                                  |
| **1880 Century Park East**                                                    |   |                                  |
| **Los Angeles, California**                                                   |   | **90067**                             |
| (Address to  principal executive offices)                                     |   | (Zip Code)                            |
|                                                                          |   |                                  |
| Issuer’s telephone number, including area code:**  (310) 277-2265** |

 

Check whether theissuer:  (1) filed all reports requiredto be filed by Section 13 or 15(d) of the Exchange Act of 1934 during thepast 12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirements forthe past 90 days.    ý  Yes          o  No

 

**APPLICABLEONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURINGTHE PRECEDING FIVE YEARS:**

 

Check whether theregistrant filed all documents and reports required to be filed bySection 12, 13 or 15(d) of the Exchange Act after the distribution ofsecurities under a plan confirmed by a court.    o  Yes          o  No

 

**APPLICABLEONLY TO CORPORATE ISSUERS:**

 

State the number ofshares outstanding of each of the issuer’s classes of common equity, as of thelatest practicable dat:  The number ofshares of Common Stock, no par value, of the issuer outstanding as ofAugust 12, 2004 was 2,917,578.

 

TransitionalSmall Business Disclosure Format (Checkone):      o  Yes     ý  No

 

 

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PART I – FINANCIALINFORMATION

 

*Item1.  Financial Statements*

 

**NATIONAL MERCANTILEBANCORP AND SUBSIDIARIES**

**CONSOLIDATED BALANCESHEETS**

 
|                                                                                                                                                                                                      |   | **June 30,  2004**     |    | **December 31,  2003** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|---------|-----------------------------|--------|
|                                                                                                                                                                                                      |   | **(Unaudited)**             |    |                        |   |
|                                                                                                                                                                                                      |   | **(Dollars  in thousands)** |    |
| ASSETS                                                                                                                                                                                                    |   |                        |    |                        |   |
| Cash  and due from banks-demand                                                                                                                                                                           |   | $                           | 21,990  |                        | $      | 24,556 |   |
| Due  from banks-interest bearing                                                                                                                                                                          |   | 2,728                       |    | 4,728                       |   |
| Federal  funds sold and securities purchased under agreements to resell                                                                                                                                   |   | 4,000                       |    | 10,000                      |   |
| Cash  and cash equivalents                                                                                                                                                                                |   | 28,718                      |    | 39,284                      |   |
| Securities  available-for-sale, at fair value; aggregate amortized cost of $48,112 and  $30,756 at June 30, 2004 and December 31, 2003, respectively                                            |   | 47,887                      |    | 30,877                      |   |
| Securities  held-to-maturity, at amortized cost                                                                                                                                                           |   | 4,025                       |    | 4,597                       |   |
| FRB  and other stock, at cost                                                                                                                                                                             |   | 2,746                       |    | 1,872                       |   |
| Loans  receivable                                                                                                                                                                                         |   | 285,585                     |    | 260,249                     |   |
| Allowance  for credit losses                                                                                                                                                                              |   | (3,691                      | )       | (3,635                      | )      |
| Net  loans receivable                                                                                                                                                                                     |   | 281,894                     |    | 256,614                     |   |
| Premises  and equipment, net                                                                                                                                                                              |   | 5,470                       |    | 5,444                       |   |
| Other  real estate owned                                                                                                                                                                                  |   | 1,010                       |    | 925                         |   |
| Deferred  tax asset                                                                                                                                                                                       |   | 6,692                       |    | 6,950                       |   |
| Goodwill                                                                                                                                                                                                  |   | 3,225                       |    | 3,225                       |   |
| Intangible  assets, net                                                                                                                                                                                   |   | 1,742                       |    | 1,854                       |   |
| Accrued  interest receivable and other assets                                                                                                                                                             |   | 3,788                       |    | 3,564                       |   |
| Total  assets                                                                                                                                                                                             |   | $                           | 387,197 |                        | $      | 355,206 |   |
|                                                                                                                                                                                                      |   |                        |    |                        |   |
| LIABILITIES  AND SHAREHOLDERS’ EQUITY                                                                                                                                                                |   |                        |    |                        |   |
| Deposits:                                                                                                                                                                                                 |   |                        |    |                        |   |
| Noninterest-bearing  demand                                                                                                                                                                               |   | $                           | 123,947 |                        | $      | 119,998 |   |
| Interest-bearing  demand                                                                                                                                                                                  |   | 30,608                      |    | 29,349                      |   |
| Money  market                                                                                                                                                                                             |   | 80,015                      |    | 55,422                      |   |
| Savings                                                                                                                                                                                                   |   | 37,664                      |    | 38,925                      |   |
| Time  certificates of deposit:                                                                                                                                                                            |   |                        |    |                        |   |
| $100,000  or more                                                                                                                                                                                         |   | 28,018                      |    | 27,308                      |   |
| Under  $100,000                                                                                                                                                                                           |   | 21,763                      |    | 27,715                      |   |
| Total  deposits                                                                                                                                                                                           |   | 322,015                     |    | 298,717                     |   |
|                                                                                                                                                                                                      |   |                        |    |                        |   |
| Federal  funds purchased and securities sold under agreements to repurchase                                                                                                                               |   | —                      |    | 399                         |   |
| Other  borrowings                                                                                                                                                                                         |   | 16,400                      |    | 7,500                       |   |
| Junior  subordinated deferrable interest debentures                                                                                                                                                       |   | 15,464                      |    | 15,464                      |   |
| Accrued  interest payable and other liabilities                                                                                                                                                           |   | 1,088                       |    | 1,405                       |   |
| Total  liabilities                                                                                                                                                                                        |   | 354,967                     |    | 323,485                     |   |
|                                                                                                                                                                                                      |   |                        |    |                        |   |
| 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 666,273 shares and 729,585 shares at June 30, 2004  and December 31, 2003, respectively |   | 5,442                       |    | 5,959                       |   |
| Series  B non-cumulative convertible perpetual preferred stock; authorized 1,000  shares; outstanding 1,000 shares at June 30, 2004 and December 31,  2003                                      |   | 1,000                       |    | 1,000                       |   |
| Common  stock, no par value; authorized 10,000,000 shares; outstanding 2,910,403  shares and 2,772,279 shares at June 30, 2004 and December 31, 2003,  respectively                             |   | 39,197                      |    | 38,602                      |   |
| Accumulated  deficit                                                                                                                                                                                      |   | (13,276                     | )       | (13,911                     | )      |
| Accumulated  other comprehensive income (loss)                                                                                                                                                            |   | (133                        | )       | 71                          |   |
| Total  shareholders’ equity                                                                                                                                                                          |   | 32,230                      |    | 31,721                      |   |
| Total  liabilities and shareholders’ equity                                                                                                                                                          |   | $                           | 387,197 |                        | $      | 355,206 |   |

 

See accompanyingnotes to consolidated financial statements.

 

2

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**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

(Unaudited)

 
|                                                                                                                      |   | **For the  Three Months Ended  June 30,**      |   | **For the  Six Months Ended  June 30,**        |   |
|---------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------|--------|-----------------------------------------------------|--------|
|                                                                                                                      |   | **2004**                                            |   | **2003**                                            |   | **2004** |   | **2003** |   |
|                                                                                                                      |   | **(Dollars  in thousands,  except per share data)** |   | **(Dollars  in thousands,  except per share data)** |   |
|                                                                                                                      |   |                                                |   |                                                |   |   |   |   |   |
| Interest  income:                                                                                                         |   |                                                |   |                                                |   |   |   |   |   |
| Loans,  including fees                                                                                                    |   | $                                                   | 3,920  |                                                | $      | 4,090 |   | $ | 7,705 |   | $ | 8,207 |   |
| Securities                                                                                                                |   | 371                                                 |   | 159                                                 |   | 670 |   | 409 |   |
| Due  from banks - interest bearing                                                                                        |   | 13                                                  |   | —                                              |   | 28 |   | — |   |
| Federal  funds sold and securities purchased under agreements to resell                                                   |   | 12                                                  |   | 133                                                 |   | 54 |   | 176 |   |
| Total  interest income                                                                                                    |   | 4,316                                               |   | 4,382                                               |   | 8,457 |   | 8,792 |   |
| Interest  expense:                                                                                                        |   |                                                |   |                                                |   |   |   |   |   |
| Interest-bearing  demand                                                                                                  |   | 19                                                  |   | 28                                                  |   | 36 |   | 89 |   |
| Money  market and savings                                                                                                 |   | 183                                                 |   | 254                                                 |   | 346 |   | 555 |   |
| Time  certificates of deposit:                                                                                            |   |                                                |   |                                                |   |   |   |   |   |
| $  100,000 or more                                                                                                        |   | 74                                                  |   | 119                                                 |   | 157 |   | 266 |   |
| Under  $100,000                                                                                                           |   | 105                                                 |   | 237                                                 |   | 218 |   | 519 |   |
| Total  interest expense on deposits                                                                                       |   | 381                                                 |   | 638                                                 |   | 757 |   | 1,429 |   |
| Federal  funds purchased and securities sold under agreements to repurchase                                               |   | 2                                                   |   | 3                                                   |   | 2 |   | 11 |   |
| Junior  subordinated deferrable interest debentures                                                                       |   | 228                                                 |   | —                                              |   | 454 |   | — |   |
| Other  borrowings                                                                                                         |   | 83                                                  |   | 89                                                  |   | 171 |   | 178 |   |
| Total  interest expense                                                                                                   |   | 694                                                 |   | 730                                                 |   | 1,384 |   | 1,618 |   |
| Net  interest income before provision for credit losses                                                                   |   | 3,622                                               |   | 3,652                                               |   | 7,073 |   | 7,174 |   |
| Provision  for credit losses                                                                                              |   | —                                              |   | 1,145                                               |   | — |   | 1,255 |   |
| Net  interest income after provision for credit losses                                                                    |   | 3,622                                               |   | 2,507                                               |   | 7,073 |   | 5,919 |   |
| Other  operating income:                                                                                                  |   |                                                |   |                                                |   |   |   |   |   |
| Net  gain on sale of securities available-for-sale                                                                        |   | —                                              |   | —                                              |   | 19 |   | 100 |   |
| International  services                                                                                                   |   | 7                                                   |   | 7                                                   |   | 21 |   | 15 |   |
| Investment  division.                                                                                                     |   | 13                                                  |   | 22                                                  |   | 25 |   | 44 |   |
| Deposit-related  and other customer services                                                                              |   | 382                                                 |   | 316                                                 |   | 802 |   | 621 |   |
| Loss  on sale of other real estate owned                                                                                  |   | —                                              |   | (61                                                 | )      | — |   | (61 | ) |
|                                                                                                                      |   |                                                |   |                                                |   |   |   |   |   |
| Total  other operating income                                                                                             |   | 402                                                 |   | 284                                                 |   | 867 |   | 719 |   |
| Other  operating expenses:                                                                                                |   |                                                |   |                                                |   |   |   |   |   |
| Salaries  and related benefits                                                                                            |   | 1,887                                               |   | 1,843                                               |   | 3,755 |   | 3,670 |   |
| Net  occupancy                                                                                                            |   | 324                                                 |   | 344                                                 |   | 615 |   | 673 |   |
| Premises  and equipment                                                                                                   |   | 162                                                 |   | 125                                                 |   | 298 |   | 234 |   |
| Printing  and communications                                                                                              |   | 148                                                 |   | 133                                                 |   | 281 |   | 262 |   |
| Insurance  and regulatory assessments                                                                                     |   | 103                                                 |   | 84                                                  |   | 220 |   | 195 |   |
| Client  services                                                                                                          |   | 148                                                 |   | 142                                                 |   | 280 |   | 320 |   |
| Computer  data processing                                                                                                 |   | 224                                                 |   | 249                                                 |   | 485 |   | 465 |   |
| Legal  services                                                                                                           |   | 78                                                  |   | 117                                                 |   | 181 |   | 260 |   |
| Other  professional services                                                                                              |   | 191                                                 |   | 182                                                 |   | 373 |   | 407 |   |
| Amortization  of core deposit intangible                                                                                  |   | 56                                                  |   | 56                                                  |   | 112 |   | 112 |   |
| Retirement  of premises and equipment                                                                                     |   | 43                                                  |   | —                                              |   | 43 |   | — |   |
| Promotion  and other expenses                                                                                             |   | 75                                                  |   | 135                                                 |   | 219 |   | 222 |   |
|                                                                                                                      |   |                                                |   |                                                |   |   |   |   |   |
| Total  other operating expenses                                                                                           |   | 3,439                                               |   | 3,410                                               |   | 6,862 |   | 6,820 |   |
| Income  (loss) before income tax provision and minority interest                                                          |   | 585                                                 |   | (619                                                | )      | 1,078 |   | (182 | ) |
|                                                                                                                      |   |                                                |   |                                                |   |   |   |   |   |
| Minority  interest in the Company’s income of the:                                                                   |   |                                                |   |                                                |   |   |   |   |   |
| Guaranteed  preferred beneficial interests in the Company’s junior subordinated  deferrable interest debentures, net |   | —                                              |   | 223                                                 |   | — |   | 456 |   |
|                                                                                                                      |   |                                                |   |                                                |   |   |   |   |   |
| Income  (loss) before income tax provision                                                                                |   | 585                                                 |   | (842                                                | )      | 1,078 |   | (638 | ) |
|                                                                                                                      |   |                                                |   |                                                |   |   |   |   |   |
| Income  tax provision (benefit)                                                                                           |   | 240                                                 |   | (323                                                | )      | 442 |   | (216 | ) |
|                                                                                                                      |   |                                                |   |                                                |   |   |   |   |   |
| Net  income (loss)                                                                                                        |   | $                                                   | 345    |                                                | $      | (519 | ) | $ | 636 |   | $ | (422 | ) |
|                                                                                                                      |   |                                                |   |                                                |   |   |   |   |   |
| Earnings  (loss) per share:                                                                                               |   |                                                |   |                                                |   |   |   |   |   |
| Basic                                                                                                                     |   | $                                                   | 0.12   |                                                | $      | (0.19 | ) | $ | 0.22 |   | $ | (0.16 | ) |
| Diluted                                                                                                                   |   | $                                                   | 0.08   |                                                | $      | (0.19 | ) | $ | 0.14 |   | $ | (0.16 | ) |
|                                                                                                                      |   |                                                |   |                                                |   |   |   |   |   |
| Weighted  average shares outstanding, basic                                                                               |   | 2,906,241                                           |   | 2,695,366                                           |   | 2,858,382 |   | 2,691,485 |   |
| Weighted  average shares outstanding, diluted                                                                             |   | 4,551,564                                           |   | 2,695,366                                           |   | 4,607,981 |   | 2,691,485 |   |

 

See accompanying notes to consolidated financial statements.

 

3

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**NATIONALMERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

(Unaudited)

 
|                                                                                          |   | **For the  Six Months Ended June 30,** |   |
|-----------------------------------------------------------------------------------------------|--------|---------------------------------------------|--------|
|                                                                                          |   | **2004**                                    |   | **2003** |   |
|                                                                                          |   | **(Dollars  in thousands)**                 |   |
| Cash  flows from operating activities:                                                        |   |                                        |   |   |   |
| Net  income (loss)                                                                            |   | $                                           | 636    |   | $ | (422 | ) |
| Adjustments  to reconcile net income to net cash provided by (used in) operating  activities: |   |                                        |   |   |   |
| Depreciation  and amortization                                                                |   | 290                                         |   | 246 |   |
| Provision  for credit losses                                                                  |   | —                                      |   | 1,255 |   |
| Gain  on sale of securities available for sale                                                |   | (19                                         | )      | (100 | ) |
| Loss  on sales of OREO                                                                        |   | —                                      |   | 61 |   |
| Net  amortization of premium on securities available-for-sale                                 |   | 109                                         |   | 113 |   |
| Net  amortization of premium on securities held-to-maturity                                   |   | 26                                          |   | — |   |
| Net  amortization of core deposit intangible                                                  |   | 112                                         |   | 112 |   |
| Net  amortization of premium on loans purchased                                               |   | 100                                         |   | 143 |   |
| Decrease  in accrued interest receivable and other assets                                     |   | 90                                          |   | 387 |   |
| Decrease  in accrued interest payable and other liabilities                                   |   | (317                                        | )      | (744 | ) |
| Net  cash provided by operating activities                                                    |   | 1,027                                       |   | 1,051 |   |
| Cash  flows from investing activities:                                                        |   |                                        |   |   |   |
| Purchase  of securities available-for-sale                                                    |   | (22,532                                     | )      | (14,536 | ) |
| Proceeds  from sales of securities available-for-sale                                         |   | 2,019                                       |   | 2,757 |   |
| Proceeds  from repayments and maturities of securities available-for-sale                     |   | 3,067                                       |   | 16,042 |   |
| Proceeds  from sales of OREO                                                                  |   | —                                      |   | 474 |   |
| Proceeds  from repayments and maturities of securities held-to-maturity                       |   | 546                                         |   | — |   |
| Loan  originations and principal collections, net                                             |   | (25,380                                     | )      | 2,846 |   |
| Redemption  (purchase) of Federal Reserve stock and other stocks                              |   | (874                                        | )      | 152 |   |
| Purchases  of premises and equipment                                                          |   | (316                                        | )      | (41 | ) |
|                                                                                          |   |                                        |   |   |   |
| Net  cash (used in) provided by investing activities                                          |   | (43,470                                     | )      | 7,694 |   |
| Cash  flows from financing activities:                                                        |   |                                        |   |   |   |
| Net  increase in demand deposits, money market and savings accounts                           |   | 28,540                                      |   | 25,907 |   |
| Net  decrease in time certificates of deposit                                                 |   | (5,242                                      | )      | (12,681 | ) |
| Net  decrease in securities sold under agreements to repurchase and federal funds  purchased  |   | (399                                        | )      | (1,081 | ) |
| Net  increase in other borrowings                                                             |   | 8,900                                       |   | — |   |
| Net  proceeds from exercise of stock options                                                  |   | 78                                          |   | 59 |   |
| Net  cash provided by financing activities                                                    |   | 31,877                                      |   | 12,204 |   |
| Net  (decrease) increase in cash and cash equivalents                                         |   | (10,566                                     | )      | 20,949 |   |
| Cash  and cash equivalents, January 1                                                    |   | 39,284                                      |   | 37,576 |   |
| Cash  and cash equivalents, June 30                                                      |   | $                                           | 28,718 |   | $ | 58,525 |   |
|                                                                                          |   |                                        |   |   |   |
| Supplemental  disclosures of cash flow information:                                           |   |                                        |   |   |   |
| Cash  paid for interest                                                                       |   | $                                           | 1,152  |   | $ | 2,207 |   |
| Transfers  to OREO from loans receivable, net                                                 |   | —                                      |   | 535 |   |
| Cash  paid for income taxes                                                                   |   | $                                           | 28     |   | $ | — |   |

 

See accompanyingnotes to consolidated financial statements.

 

4

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**NATIONAL MERCANTILE BANCORP ANDSUBSIDIARIES**

###### **NOTES TO THE UNAUDITED CONSOLIDATED FINANCIALSTATEMENTS**

 

NOTE 1—BASIS OFPRESENTATION AND MANAGEMENT REPRESENTATIONS

 

The unauditedconsolidated financial statements include the accounts of National MercantileBancorp (“National Mercantile” on a parent-only basis, and the ‘‘Company’’ on aconsolidated basis) and its wholly owned subsidiaries, Mercantile National Bankand South Bay Bank, N.A., (collectively, “the Banks”). The Company adopted FASBInterpretation No. 46 Consolidation of Variable Interest Entities effectiveJuly 1, 2003 and accordingly the accounts of National Mercantile CapitalTrust I are not included in the consolidated balance sheet at June 30,2004 or the consolidated statement of operations for the three and six monthsthen ended.   The unaudited consolidatedfinancial statements reflect all interim adjustments, which are of a normalrecurring nature and which, in management’s opinion, are necessary for the fairpresentation of the Company’s consolidated financial position and results ofoperations and cash flows for such interim periods. The results for the threeand six months ended June 30, 2004 are not necessarily indicative of theresults expected for any subsequent period or for the full year endingDecember 31, 2004. The unaudited consolidated financial statements shouldbe read in conjunction with the audited consolidated financial statementsincluded in the Company’s Annual Report on Form 10-KSB for the year endedDecember 31, 2003.

 

NOTE 2—EARNINGS PER SHARE

 

Basic earnings per shareare computed using the weighted average number of common shares outstandingduring the period.  The weighted averagenumber of common shares outstanding used in computing basic earnings per shareand diluted earnings per share was 2,906,241 and 4,551,564, respectively, forthe three months ended June 30, 2004 and 2,858,382 and 4,607,981,respectively, for the six months ended June 30, 2004.   The weighted average number of commonshares outstanding used in computing basic and diluted loss per share for thethree months ended June 30, 2003 was 2,695,366 and 2,691,485 for the sixmonths ended June 30, 2003.

 

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

 

5

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|                                             |   | **Earnings  available to  shareholders** |   | **Weighted  Average  Shares** |      | **Per share  amount** |   |
|--------------------------------------------------|--------|------------------------------------------|--------|-------------------------------|-----------|-----------------------|--------|
|                                             |   | **(in  thousands)**                      |   |                          |      |                  |   |
|                                             |   |                                     |   |                          |      |                  |   |
| *For the three months ended June 30, 2004:* |   |                                     |   |                          |      |                  |   |
| Basic  earnings per share                        |   | $                                        | 345    |                          | 2,906,241 |                  | $      | 0.12 |   |
|                                             |   |                                     |   |                          |      |                  |   |
| Effect  of dilutive securities:                  |   |                                     |   |                          |      |                  |   |
| Options                                          |   |                                     |   | 140,001                       |      |                  |   |
| Convertible  preferred stock                     |   |                                     |   | 1,505,322                     |      |                  |   |
| Diluted  earnings per share                      |   | $                                        | 345    |                          | 4,551,564 |                  | $      | 0.08 |   |
|                                             |   |                                     |   |                          |      |                  |   |
| *For the three months ended June 30, 2003:* |   |                                     |   |                          |      |                  |   |
| Basic  and diluted loss per share                |   | $                                        | (519   | )                             | 2,695,366 |                  | $      | (0.19 | ) |
|                                             |   |                                     |   |                          |      |                  |   |
| *For the six months ended June 30, 2004:*   |   |                                     |   |                          |      |                  |   |
| Basic  earnings per share                        |   | $                                        | 636    |                          | 2,858,382 |                  | $      | 0.22 |   |
|                                             |   |                                     |   |                          |      |                  |   |
| Effect  of dilutive securities:                  |   |                                     |   |                          |      |                  |   |
| Options                                          |   |                                     |   | 245,782                       |      |                  |   |
| Convertible  preferred stock                     |   |                                     |   | 1,503,817                     |      |                  |   |
| Diluted  earnings per share                      |   | $                                        | 636    |                          | 4,607,981 |                  | $      | 0.14 |   |
|                                             |   |                                     |   |                          |      |                  |   |
| *For the six months ended June 30, 2003:*   |   |                                     |   |                          |      |                  |   |
| Basic  and diluted loss per share                |   | $                                        | (422   | )                             | 2,691,485 |                  | $      | (0.16 | ) |

 

NOTE 3—CASH AND CASHEQUIVALENTS

 

For purposes of reportingcash flows, cash and cash equivalents include cash, due from banks-demand, duefrom banks-interest-bearing and federal funds sold.

 

NOTE 4—ALLOWANCE FORCREDIT LOSSES 

 

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

 

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

 

6

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**Analysis of Changes in Allowance for Credit Losses**

 
|                                                                                  |   | **Three  months ended**     |   | **Six months  ended**       |   |
|---------------------------------------------------------------------------------------|--------|-----------------------------|--------|-----------------------------|--------|
|                                                                                  |   | **June 30,  2004**     |   | **June 30,  2003**     |   | **June 30,  2004** |   | **June 30,  2003** |   |
|                                                                                  |   | **(Dollars  in thousands)** |   | **(Dollars  in thousands)** |   |
|                                                                                  |   |                        |   |                        |   |   |   |   |   |
| Balance,  beginning of period                                                         |   | $                           | 3,633  |                        | $      | 4,694 |   | $ | 3,635 |   | $ | 4,846 |   |
| Loans  charged off:                                                                   |   |                        |   |                        |   |   |   |   |   |
| Real  estate loans:                                                                   |   |                        |   |                        |   |   |   |   |   |
| Secured  by one to four family residential properties                                 |   | —                      |   | 15                          |   | — |   | 38 |   |
| Secured  by multifamily residential properties                                        |   | —                      |   | —                      |   | — |   | — |   |
| Secured  by commercial real properties                                                |   | —                      |   | 75                          |   | — |   | 75 |   |
| Real  estate construction and land development                                        |   | —                      |   | —                      |   | — |   | — |   |
| Commercial  - secured and unsecured                                                   |   | —                      |   | 2,318                       |   | 31 |   | 2,697 |   |
| Consumer  installment, home equity lines of credit and unsecured loans to individuals |   | —                      |   | 33                          |   | 4 |   | 33 |   |
|                                                                                  |   |                        |   |                        |   |   |   |   |   |
| Total  loans charged-off                                                              |   | —                      |   | 2,441                       |   | 35 |   | 2,843 |   |
|                                                                                  |   |                        |   |                        |   |   |   |   |   |
| Recoveries  of loans previously charged off:                                          |   |                        |   |                        |   |   |   |   |   |
| Real  estate loans:                                                                   |   |                        |   |                        |   |   |   |   |   |
| Secured  by one to four family residential properties                                 |   | —                      |   | —                      |   | — |   | — |   |
| Secured  by multifamily residential properties                                        |   | —                      |   | —                      |   | — |   | — |   |
| Secured  by commercial real properties                                                |   | —                      |   | —                      |   | — |   | — |   |
| Real  estate construction and land development                                        |   | —                      |   | —                      |   | 6 |   | — |   |
| Commercial  - secured and unsecured                                                   |   | 57                          |   | 47                          |   | 68 |   | 133 |   |
| Consumer  installment, home equity lines of credit and unsecured loans to individuals |   | 1                           |   | 7                           |   | 17 |   | 61 |   |
|                                                                                  |   |                        |   |                        |   |   |   |   |   |
| Total  recoveries of loans previously charged off                                     |   | 58                          |   | 54                          |   | 91 |   | 194 |   |
| Net  charge-offs (recoveries)                                                         |   | (58                         | )      | 2,387                       |   | (56 | ) | 2,649 |   |
| Provision  for credit losses                                                          |   | —                      |   | 1,145                       |   | — |   | 1,255 |   |
|                                                                                  |   |                        |   |                        |   |   |   |   |   |
| Balance,  end of period                                                               |   | $                           | 3,691  |                        | $      | 3,452 |   | $ | 3,691 |   | $ | 3,452 |   |

 

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

 

7

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NOTE 5—GOODWILL AND OTHER INTANGIBLE ASSETS

 

As of June 30, 2004and December 31, 2003, the Company had goodwill of $3.2 million, and netcore deposit intangibles of $1.7 million and $1.9 million, respectively, fromits acquisition of South Bay Bank in December 2001.  The gross carrying amount of core depositintangibles was $2.3 million at June 30, 2004 and December 31, 2003,and accumulated amortization was $559,000 and $447,000, respectively, at suchdates.  The core deposit intangibles areestimated to have a life of 10 years and 4 months. Amortization for intangiblesfor 2004 and each of the next four years is estimated to be $223,000 peryear.  In accordance with SFAS No. 142goodwill is not amortized.  The Companyhas no other recorded indefinite-lived intangible assets.  Goodwill and other intangible assets arereviewed and assessed annually for impairment.

 

NOTE 6—INCOME TAXES

 

An income tax provisionof $240,000 and income tax benefit of $323,000 were recorded for the threemonths ended June 30, 2004 and 2003, respectively.  Income tax provision of $442,000 and incometax benefit of $216,000 were recorded for the six months ended June 30,2004 and 2003, respectively.

 

At June 30, 2004,the Company had: (i) federal net operating loss carry forwards (“NOLS”) ofapproximately $18.4 million, which begin to expire in the year 2009; (ii)California NOLS of $273,000 which will expire in 2005; (iii) a federalalternative minimum tax “AMT” credit of $298,000; and (iv) a California AMT of$16,000.  The California NOLS werescheduled to expire in 2002; the state legislature suspended NOLS utilizationand extended the related carry forwards expiration.  The AMT credits carry forward indefinitely.

 

Management believes thatit is more likely than not that the deferred tax asset will be realized.  Accordingly, no valuation allowance has beenestablished against the deferred tax asset.

 

NOTE 7—BENEFIT PLANS

 

The estimated per shareweighted average fair value of options granted was $6.85 and $4.81 for thethree months ended June 30, 2004 and 2003, respectively.  The estimated per share weighted averagefair value of options granted was $6.95 and $4.73 for the six months endedJune 30, 2004 and 2003, respectively. The Company applies AccountingPrinciples Board Opinion No. 25 and related Interpretations in accounting forits stock incentive plans.  SFAS No.123, Accounting for Stock-Based Compensation, encourages, but does not require,companies to record compensation cost for stock-based employee compensationplans at fair value.  Accordingly, nocompensation cost has been recognized for the options.  Had compensation

 

8

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cost for the optionsgranted been determined based on the fair value at the grant dates for awardsconsistent with the method of SFAS No. 123, the Company’s net income for thethree months ended June 30, 2004 and 2003 would have decreased by $30,000and $28,000, respectively.  Basic anddiluted earnings per share would have decreased by $0.01 for the three monthsended June 30, 2004 and basic and diluted loss per share would haveincreased by $0.01 for the three months ended June 30, 2003.  Had compensation cost for the optionsgranted been determined based on the fair value at the grant dates for awardsconsistent with the method of SFAS No. 123, the Company’s net income for thesix months ended June 30, 2004 and 2003 would have decreased by $57,000and $66,000 respectively.  Basicearnings per share would have decreased by $0.02 for the six months endedJune 30, 2004 and diluted earnings per share would have decreased by $0.01for the six months ended June 30, 2004.  Basic and diluted loss per share would have increased by $0.02 forthe six months ended June 30, 2003.

 

The fair values ofoptions granted during the three months ended June 30, 2004 and 2003 wereestimated on the date of grant using the Black-Scholes option-pricing modelwith the following weighted-average assumptions used: 2004— no dividend yield,expected volatility of 57%, risk-free interest rate of 4.60%, and an expectedlife of 10 years; 2003— no dividend yield, expected volatility of 59%, risk-freeinterest rate of 4.81%, and an expected life of 10 years.

 

NOTE 8—COMPREHENSIVE INCOME (LOSS)

 

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

 

9

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|                                                                                |   | **For the Three  months ended  June 30,** |   | **For the  Six months ended  June 30,** |   |
|-------------------------------------------------------------------------------------|--------|------------------------------------------------|--------|----------------------------------------------|--------|
|                                                                                |   | **2004**                                       |   | **2003**                                     |   | **2004** |   | **2003** |   |
|                                                                                |   | **(in  thousands)**                            |   | **(in  thousands)**                          |   |
|                                                                                |   |                                           |   |                                         |   |   |   |   |   |
| Net  income (loss)                                                                  |   | $                                              | 345    |                                         | $      | (519 | ) | $ | 636 |   | $ | (422 | ) |
|                                                                                |   |                                           |   |                                         |   |   |   |   |   |
| Other  comprehensive income (loss) before tax, and unrealized losses on securities: |   |                                           |   |                                         |   |   |   |   |   |
| Unrealized  gain (loss) on securities available for sale                            |   | (377                                           | )      | (32                                          | )      | (346 | ) | (220 | ) |
| Other  comprehensive income (loss), before tax                                      |   | (377                                           | )      | (32                                          | )      | (346 | ) | (220 | ) |
|                                                                                |   |                                           |   |                                         |   |   |   |   |   |
| Income  tax benefit related to items of other comprehensive income                  |   | 155                                            |   | 13                                           |   | 142 |   | 91 |   |
| Other  comprehensive income (loss)                                                  |   | (222                                           | )      | (19                                          | )      | (204 | ) | (129 | ) |
| Total  comprehensive income (loss)                                                  |   | $                                              | 123    |                                         | $      | (538 | ) | $ | 432 |   | $ | (551 | ) |

 

NOTE 9—JUNIOR SUBORDINATED DEFERRABLE INTERESTDEBENTURES

 

In 2001, NationalMercantile, through National Mercantile Capital Trust I (the “Trust”), issued15,000 of 10.25% fixed-rate preferred securities due July 25, 2031 (the“Trust Preferred Securities”), with a liquidation amount of $1,000 per TrustPreferred Security and an aggregate liquidation amount of $15.0 million. The Trust Preferred Securities represent undivided beneficial interests in theassets of the Trust and are guaranteed by National Mercantile only with respectto distributions and payments upon liquidation, redemption and otherwisepursuant to the terms of a guarantee agreement.

 

The primary assets of theTrust are $15.5 million aggregate principal amount of National Mercantile’s10.25% fixed-rate junior subordinated deferrable interest debentures dueJuly 25, 2031, (the “Junior Subordinated Debentures”) that pay interesteach January 25 and July 25. The interest is deferrable, at National Mercantile’s option, for aperiod up to ten consecutive semi-annual payments, but in any event not beyondJune 25, 2031.  The debentures areredeemable, in whole or in part, at National Mercantile’s option on or afterfive years from issuance at declining premiums to maturity.

 

The Company adopted FASBInterpretation No. 46, Consolidation of Variable Interest Entities (FIN 46) asof July 1, 2003 resulting in the deconsolidation of the Trust.Accordingly, the Junior Subordinated Debentures have been classified inliabilities at June 30, 2004 and the related interest was classified asinterest expense for the three and six months then ended.  For dates and periods prior to the adoptionof FIN 46, the Trust Preferred Securities, net of the cost of issuance, wererecorded as a minority interest and the related interest was recorded as aminority interest in the Company’s income.

 

10

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NOTE 10—DERIVATIVE FINANCIAL INSTRUMENTS

 

In January 2003,National Mercantile entered into an interest rate swap agreement pursuant towhich it exchanged a fixed rate payment obligation of 10.25% on a notionalprincipal amount of $15.0 million for a floating rate interest based on thesix-month London InterBank Offered Rate plus 458 basis points for a 29-yearperiod ending July 25, 2031.  Theinterest rate swap agreement results in National Mercantile paying or receivingthe difference between the fixed and floating rates at specified intervalscalculated on the notional amounts.  Thedifferential paid or received on the interest rate swap is recognized as anadjustment to interest expense.  AtJune 30, 2004, National Mercantile was paying an interest rate of 5.75%under the terms of the swap.  Thecounter party to the swap has the option to call the swap under a decliningpremium schedule beginning July 2006.

 

The interest rate swapreduces the cost of the 10.25% fixed-rate Junior Subordinated Debentures in alow interest rate environment.  TheCompany 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.  The termsof the swap are symmetrical with the terms of the Junior Subordinated Debentures,including the payment deferral terms, and considered highly effective inoffsetting changes in fair value of the Junior Subordinated Debentures.  An $837,000 decrease in the fair value ofthe swap was recorded in income for the three-month period ended June 30,2004 with an offsetting charge to earnings to reflect a similar decrease in thefair value of the Junior Subordinated Debentures.   No ineffectiveness was recorded to current earnings related tothe interest rate swap.

 

The terms of the swap requireNational Mercantile to provide collateral to support its contract obligationsand varies based upon the swap contract value. At June 30, 2004, $1.8 million in cash and securities were pledgedas collateral.

 

NOTE 11— CONVERSION OFPREFERRED STOCK

 

During the six monthsended June 30, 2004, 63,312 shares of Series A non-cumulative convertibleperpetual preferred stock were converted into 126,624 shares of common stock.

 

NOTE 12—RECLASSIFICATIONS

 

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

 

11

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NOTE 13—SUBSEQUENT EVENT

 

On July 1, 2004, theBanks entered into interest rate swap agreements in which they exchanged anadjustable rate interest based on the prime rate lending index for a fixed ratepayment of 6.925% on an aggregate notional principal amount beginning at $50.0million for a 4-year period, declining to $30.0 million for the fifth year and$10.0 million for the sixth year with a final maturity of June 30,2010.  The interest rate swap agreementresults in the Banks paying or receiving the difference between the fixed andfloating rates at monthly intervals calculated on the notional amounts.  The differential paid or received on theinterest rate swap will be recognized as an adjustment to interest income.  At July 1, 2004, the Banks were payingan interest rate of 4.25% under the terms of the swap.

 

These interest rate swapsreduce the current asset sensitivity of the Company’s balance sheet moderatingthe potential negative impact on earnings in the event of declining interestrates.  The Company does not utilizederivatives for speculative purposes. Under Statement of Financial Accounting Standards No. 133 these swaptransactions are designated as cash flow hedges.  Accordingly, the change in fair value of the swaps is recordedeach period as other comprehensive income and any ineffective portion of thechange in the fair value is recorded in current income.  The Company has a large portion of its loanportfolio that adjusts to changes in the prime rate lending index and thereforethe swaps are currently considered highly effective in offsetting changes inthe cash flows of the loan portfolio.

 

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

 

National MercantileBancorp (“National Mercantile” on a parent-only basis, and the ‘‘Company’’ on aconsolidated basis) is the holding company for two subsidiary banks, MercantileNational Bank (“Mercantile”) and South Bay Bank, N.A. (“South Bay”)(collectively, “the Banks”).  NationalMercantile’s principal assets are the capital stock of Mercantile and SouthBay.

 

In July 2001,National Mercantile formed National Mercantile Capital Trust (the “Trust”) as aDelaware statutory business trust formed for the exclusive purpose of issuingand selling trust preferred securities (the “Trust Preferred Securities”).  The Trust issued those securities andutilized the proceeds to purchase from National Mercantile, its junior subordinateddeferrable interest debentures (the “Junior Subordinated Debentures”).  Through June 30, 2003, the Company’sfinancial statements reflected the Trust as a consolidated subsidiary, with theeffect that the Trust Preferred Securities of the Trust reflected on the

 

12

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balance sheet asmezzanine equity and payments on the Trust Preferred Securities were set forthas minority interest in the Company’s income of the guaranteed preferredbeneficial interest in the Junior Subordinated Debentures.

 

The Company implementedFIN 46 effective July 1, 2003 with the effect that since that date theTrust has not been a consolidated subsidiary of the Company for financialreporting purposes.  As a result: (i)the Company’s balance sheets as of dates on or after July 1, 2003 nolonger reflect the Trust Preferred Securities as mezzanine equity but insteadreflect the Junior Subordinated Debentures as liabilities, and (ii) theCompany’s statements of operations incorporating periods on or afterJuly 1, 2003, reflect from July 1, 2003 forward interest payments onthe Junior Subordinated Debentures as interest expense and do not reflectpayments on the Trust Preferred Securities as expenses classified as minorityinterest in the Company’s income of the guaranteed preferred beneficialinterest in the Company’s Junior Subordinated Debentures.  As discussed below, this has a significanteffect on comparisons of net interest income between periods including and notincluding periods on and after July 1, 2003.

 

**RESULTS OF OPERATIONS**

 

The Company recorded netincome of $345,000, or $0.12 basic earnings per share and $0.08 diluted earningper share, for the three months ended June 30, 2004 compared to a net lossof $519,000, or $0.19 basic and diluted loss per share, for the same period of2003.   The increase in net income forthe 2004 period was primarily due to a $1,145,000 reduction in the provisionfor credit losses as well as a $118,000 increase in other operating income, anda $257,000 reduction in interest expense on deposits. This was partially offsetby a $66,000 reduction in total interest income, a $29,000 increase in otheroperating expenses and a $563,000 increase in income tax provisions.

 

The Company recorded netincome of $636,000, or $0.22 basic earnings per share and $0.14 diluted earningper share, for the six months ended June 30, 2004 compared to a net lossof $422,000, or $0.16 basic and diluted loss per share, for the same period of2003.  The increase in net income forthe 2004 period was primarily due to a $1,255,000 reduction in the provisionfor credit losses as well as a $148,000 increase in other operating income anda $234,000 reduction in interest expense. This was partially offset by a $335,000 reduction in total interestincome, a $42,000 increase in other operating expenses and a $658,000 increasein income tax provisions.

 

Return on average assetsduring the second quarter and first half of 2004 was 0.37% and 0.35%respectively, compared to a minus 0.56% and 0.24% during the second quarter

 

13

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and first half of 2003.Return on average equity during the second quarter and first half of 2004 was4.28% and 3.95%, respectively, compared to a negative 6.58% and 2.70% duringthe second quarter and first half of 2003, respectively.

 

NET INTEREST INCOME

 

Net interest incomebefore the provision for credit losses decreased $30,000 for the second quarterof 2004 compared to the second quarter of 2003 due to the inclusion of  $228,000 interest on the Junior SubordinatedDebentures in the 2004 quarter.  Thisaccounting change also resulted in the net interest margin (net yield oninterest earning assets) being lower in the second quarter of 2004 (4.38%) thanthe second quarter of 2003 (4.44%). Income and expenses on interest earning assets and interest bearingliabilities during these periods were affected by declining market interestrates as a result of the Federal Reserve Board’s reduction in the federal fundsrate in response to the slow economy.

 

Interest income decreasedfor the second quarter 2004 due to a 0.12% decline in the weighted averageyield on interest earning assets despite a $3.4 million increase in averageinterest earning assets.  The reductionin the weighted average yield on interest earning assets was due to a declinein market interest rates, resulting in a repricing of adjustable rate assets(primarily loans) and lower yields on renewed loans and newly originated orpurchased assets.  Loan yields declined39 basis points in the 2004 period compared to 2003.  The decline in interest income was partially mitigated by achange in the composition of earning assets. The average volume of lower yielding federal funds sold and securitiespurchased under agreement to resell declined $36.8 million for the three monthsended June 30, 2004 while the average volumes of higher yieldingsecurities available-for-sale and securities held-to-maturity increased $25.3million and $4.2 million, respectively, and the average volume of loansreceivable increased $6.5 million.  Thegrowth in securities was due to additional investments of relatively short-terminstruments in an interest rate environment that management viewed asfavorable.  The growth in loans receivablewas largely due to the emphasis on business development through the hiring ofseasoned commercial lending officers.

 

Interest expense for thesecond quarter 2004 decreased due to a 0.20% decline in the weighted averagerates on interest bearing liabilities, which more than offset a $20.0 millionincrease in average interest-bearing liabilities. The reduction in the weightedaverage rate was due to a decline in market interest rates and an increase inlower-cost demand, savings and money market deposits and reduction inhigher-cost certificates of deposit. The decline in interest expense was offset in part by the inclusion ofinterest on the higher cost Junior Subordinated Debentures as interest expensedescribed above and an increase in other borrowings.  Interest bearing demand, and money market and savings depositsincreased $4.8 million and $13.8 million,

 

14

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respectively, as a resultof the additional resources expended to develop business banking.  Time certificates of deposit decreased $16.7million due to pricing designed to encourage run-off at maturity.

 

Net interest incomebefore the provision for credit losses decreased $101,000 for the six monthsended June 30, 2004 compared to the same period of 2003 due to theinclusion of $454,000 interest on the Junior Subordinated Debentures in the2004 quarter.  This accounting changealso resulted in the net interest margin (net yield on interest earning assets)being lower in the six months ended June 30, 2004 (4.36%) than the sameperiod in 2003 (4.52%). Income and expenses on interest earning assets andinterest bearing liabilities during these periods were affected by decliningmarket interest rates as a result of the Federal Reserve Board’s reduction inthe federal funds rate in response to the slow economy.

 

Interest income decreaseddue to a 0.32% decline in the weighted average yield on interest earning assetsdespite a $6.0 million increase in average interest earning assets.  The reduction in the weighted average yieldon interest earning assets was due to: (i) a decline in market interest rates,resulting in a repricing of adjustable rate assets (primarily loans) and loweryields on renewed loans and newly originated or purchased assets, and (ii) loweryielding assets comprising a greater portion of our interest earning assets,due to a decline in average loans.  Theyield on loans receivable declined 36 basis points for the 2004 period comparedto 2003 and loans receivable averaged $1.6 million less in the first half of2004 compared to the same period in 2003, due to a lower volume of loans earlyin 2004.  The decline in interest incomewas moderated by a change in the composition of earning assets.  The average volume of lower-yielding federalfunds sold and securities purchased under agreements to resell declined $17.2million for the six months ended June 30, 2004 while the average volumesof higher- yielding securities available-for–sale and securitiesheld-to-maturity increased $16.0 million and $4.4 million, respectively.

 

Interest expensedecreased due to a 0.34% decline in the weighted average rates on interestbearing liabilities, which more than offset a $14.5 million increase in averageinterest-bearing liabilities. The reduction in the weighted average rate wasdue to: (i) a decline in market interest rates and (ii) an increase inlower-cost demand, savings and money market deposits and reduction inhigher-cost certificates of deposits. This was offset in part by the inclusion of interest on the higher costJunior Subordinated Debentures as interest expense.  Interest bearing demand, and money market and savings depositsincreased $3.6 million and $12.6 million, respectively, as a result of the additionalresources expended to develop business banking.  Time certificates of deposit decreased $18.0 million due to moreaggressive pricing practices.

 

The following tablepresents the components of net interest income for the three months endedJune 30, 2004 and 2003.

 

15

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**Average Balance Sheet and**

**Analysis of Net Interest Income**

 
|                                                                                                                      |   | **Three  months ended**     |    |
|---------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|---------|
|                                                                                                                      |   | **June 30,  2004**     |    | **June 30,  2003** |   |
|                                                                                                                      |   | **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                                                   |   | $                           | 4,623   |   | 12 |   | 1.04 | % | $ | 41,409 |   | $ | 133 |   | 1.29 | % |
| Due  from banks-interest bearing                                                                                          |   | 4,091                       |    | 13 |   | 1.28 | % | — |   | — |   | — |   |
| Securities  available-for-sale                                                                                            |   | 46,495                      |    | 346 |   | 2.98 | % | 21,147 |   | 159 |   | 3.01 | % |
| Securities  held-to-maturity                                                                                              |   | 4,245                       |    | 25 |   | 2.31 | % | — |   | — |   | — |   |
| Loans  receivable (1) (2)                                                                                                 |   | 273,042                     |    | 3,920 |   | 5.77 | % | 266,520 |   | 4,090 |   | 6.16 | % |
| Total  interest earning assets                                                                                            |   | 332,496                     |    | 4,316 |   | 5.22 | % | 329,076 |   | 4,382 |   | 5.34 | % |
|                                                                                                                      |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Noninterest  earning assets:                                                                                              |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Cash  and due from banks - demand                                                                                         |   | 23,194                      |    |   |   |   |   | 22,045 |   |   |   |   |   |
| Other  assets                                                                                                             |   | 21,796                      |    |   |   |   |   | 22,537 |   |   |   |   |   |
| Allowance  for credit losses and net unrealized gain on sales of securities  available-for-sale                           |   | (3,695                      | )       |   |   |   |   | (4,518 | ) |   |   |   |   |
| Total  assets                                                                                                             |   | $                           | 373,791 |   |   |   |   |   | $ | 369,140 |   |   |   |   |   |
|                                                                                                                      |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Liabilities  and shareholders’ equity:                                                                               |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  deposits:                                                                                               |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Demand                                                                                                                    |   | $                           | 32,426  |   | 19 |   | 0.24 | % | $ | 27,592 |   | $ | 28 |   | 0.41 | % |
| Money  market and savings                                                                                                 |   | 113,038                     |    | 183 |   | 0.65 | % | 99,262 |   | 254 |   | 1.03 | % |
| Time  certificates of deposit:                                                                                            |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| $100,000  or more                                                                                                         |   | 21,675                      |    | 74 |   | 1.37 | % | 30,643 |   | 119 |   | 1.56 | % |
| Under  $100,000                                                                                                           |   | 26,381                      |    | 105 |   | 1.60 | % | 34,117 |   | 237 |   | 2.79 | % |
| Total  time certificates of deposit                                                                                       |   | 48,056                      |    | 179 |   | 1.50 | % | 64,760 |   | 356 |   | 2.20 | % |
| Total  interest-bearing deposits                                                                                          |   | 193,520                     |    | 381 |   | 0.79 | % | 191,614 |   | 638 |   | 1.34 | % |
| Other  borrowings                                                                                                         |   | 10,524                      |    | 83 |   | 3.17 | % | 7,500 |   | 89 |   | 4.76 | % |
| Junior  subordinated debentures                                                                                           |   | 15,464                      |    | 228 |   | 5.93 | % | — |   | — |   | — |   |
| Federal  funds purchased and securities sold under agreements to repurchase                                               |   | 132                         |    | 2 |   | 6.09 | % | 538 |   | 3 |   | 2.24 | % |
| Total  interest-bearing liabilities                                                                                       |   | 219,640                     |    | 694 |   | 1.27 | % | 199,652 |   | 730 |   | 1.47 | % |
|                                                                                                                      |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  liabilities:                                                                                         |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  demand deposits                                                                                      |   | 120,734                     |    |   |   |   |   | 122,110 |   |   |   |   |   |
| Other  liabilities                                                                                                        |   | 1,080                       |    |   |   |   |   | 1,228 |   |   |   |   |   |
| Guaranteed  preferred beneficial interests in the Company’s junior subordinated  deferrable interest debentures, net |   | —                      |    |   |   |   |   | 14,536 |   |   |   |   |   |
| Shareholders’  equity                                                                                                |   | 32,337                      |    |   |   |   |   | 31,614 |   |   |   |   |   |
| Total  liabilities and shareholders’ equity                                                                          |   | $                           | 373,791 |   |   |   |   |   | $ | 369,140 |   |   |   |   |   |
|                                                                                                                      |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Net  interest income (spread)                                                                                             |   |                        |    | $ | 3,622 |   | 3.95 | % |   |   | $ | 3,652 |   | 3.87 | % |
|                                                                                                                      |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Net  yield on interest earning assets (2)                                                                                 |   |                        |    |   |   | 4.38 | % |   |   |   |   | 4.45 | % |
|                                                                                                                           |        |                             |         |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

(2)          Yieldsand amounts earned on loans receivable include loan fees of $275,000 and$227,000 for the three months ended June 30, 2004 and 2003, respectively.

 

16

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The following tablepresents the components of net interest income for the six months endedJune 30, 2004 and 2003.

 

**Average Balance Sheet and**

**Analysis of Net Interest Income**

 
|                                                                                                                      |   | **Six months  ended**       |    |
|---------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|---------|
|                                                                                                                      |   | **June 30,  2004**     |    | **June 30,  2003** |   |
|                                                                                                                      |   | **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                                                   |   | $                           | 11,029  |   | 54 |   | 0.98 | % | $ | 28,196 |   | $ | 176 |   | 1.26 | % |
| Due  from banks-interest bearing                                                                                          |   | 4,394                       |    | 28 |   | 1.28 | % | — |   | — |   | — |   |
| Securities  available-for-sale                                                                                            |   | 39,707                      |    | 590 |   | 2.97 | % | 23,749 |   | 409 |   | 3.44 | % |
| Securities  held-to-maturity                                                                                              |   | 4,377                       |    | 80 |   | 3.66 | % | — |   | — |   | — |   |
| Loans  receivable (1) (2)                                                                                                 |   | 266,353                     |    | 7,705 |   | 5.82 | % | 267,911 |   | 8,207 |   | 6.18 | % |
| Total  interest earning assets                                                                                            |   | 325,860                     |    | 8,457 |   | 5.22 | % | 319,856 |   | 8,792 |   | 5.54 | % |
|                                                                                                                      |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Noninterest  earning assets:                                                                                              |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Cash  and due from banks - demand                                                                                         |   | 23,078                      |    |   |   |   |   | 21,437 |   |   |   |   |   |
| Other  assets                                                                                                             |   | 21,646                      |    |   |   |   |   | 21,348 |   |   |   |   |   |
| Allowance  for credit losses and net unrealized gain on sales of securities  available-for-sale                           |   | (3,611                      | )       |   |   |   |   | (4,507 | ) |   |   |   |   |
| Total  assets                                                                                                             |   | $                           | 366,973 |   |   |   |   |   | $ | 358,134 |   |   |   |   |   |
|                                                                                                                      |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Liabilities  and shareholders’ equity:                                                                               |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  deposits:                                                                                               |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Demand                                                                                                                    |   | $                           | 31,176  |   | 36 |   | 0.23 | % | $ | 27,621 |   | $ | 89 |   | 0.65 | % |
| Money  market and savings                                                                                                 |   | 106,794                     |    | 346 |   | 0.65 | % | 94,147 |   | 555 |   | 1.19 | % |
| Time  certificates of deposit:                                                                                            |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| $100,000  or more                                                                                                         |   | 22,908                      |    | 157 |   | 1.38 | % | 31,352 |   | 266 |   | 1.71 | % |
| Under  $100,000                                                                                                           |   | 26,370                      |    | 218 |   | 1.66 | % | 35,915 |   | 519 |   | 2.91 | % |
| Total  time certificates of deposit                                                                                       |   | 49,278                      |    | 375 |   | 1.53 | % | 67,267 |   | 785 |   | 2.35 | % |
| Total  interest-bearing deposits                                                                                          |   | 187,248                     |    | 757 |   | 0.81 | % | 189,035 |   | 1,429 |   | 1.52 | % |
| Other  borrowings                                                                                                         |   | 9,012                       |    | 171 |   | 3.82 | % | 7,500 |   | 178 |   | 4.79 | % |
| Junior  subordinated debentures                                                                                           |   | 15,464                      |    | 454 |   | 5.90 | % | — |   | — |   | — |   |
| Federal  funds purchased and securities sold under agreements to repurchase                                               |   | 181                         |    | 2 |   | 2.22 | % | 834 |   | 11 |   | 2.66 | % |
| Total  interest-bearing liabilities                                                                                       |   | 211,905                     |    | 1,384 |   | 1.31 | % | 197,369 |   | 1,618 |   | 1.65 | % |
|                                                                                                                      |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  liabilities:                                                                                         |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  demand deposits                                                                                      |   | 121,965                     |    |   |   |   |   | 113,942 |   |   |   |   |   |
| Other  liabilities                                                                                                        |   | 848                         |    |   |   |   |   | 803 |   |   |   |   |   |
| Guaranteed  preferred beneficial interests in the Company’s junior subordinated  deferrable interest debentures, net |   | —                      |    |   |   |   |   | 14,534 |   |   |   |   |   |
| Shareholders’  equity                                                                                                |   | 32,255                      |    |   |   |   |   | 31,486 |   |   |   |   |   |
| Total  liabilities and shareholders’ equity                                                                          |   | $                           | 366,973 |   |   |   |   |   | $ | 358,134 |   |   |   |   |   |
|                                                                                                                      |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Net  interest income (spread)                                                                                             |   |                        |    | $ | 7,073 |   | 3.91 | % |   |   | $ | 7,174 |   | 3.89 | % |
|                                                                                                                      |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Net  yield on interest earning assets (2)                                                                                 |   |                        |    |   |   | 4.36 | % |   |   |   |   | 4.52 | % |
|                                                                                                                           |        |                             |         |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

(2)          Yieldsand amounts earned on loans receivable include loan fees of $568,000 and$417,000 for the three months ended June 30, 2004 and 2003, respectively.

 

17

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

 

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

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

 
|                                                                        |   | **Six months  ended June 30,  2004 vs 2003** |   |
|-----------------------------------------------------------------------------|--------|---------------------------------------------------|--------|
|                                                                        |   |                                              |   |   |   | **Net  Increase(Decrease)** |   |
| **Increase  (decrease) due to:**                                            |
| **Volume**                                                                  |   | **Rate**                                          |
| Interest  Income:                                                           |   |                                              |   |   |   |   |   |
| Federal  funds sold and securities purchased under agreement to resell      |   | $                                                 | (107   | ) | $ | (15 | ) | $ | (122 | ) |
| Interest-bearing  deposits with other financial institutions                |   | 28                                                |   | — |   | 28 |   |
| Securities  available-for-sale                                              |   | 274                                               |   | (93 | ) | 181 |   |
| Securities  held-to-maturity                                                |   | 80                                                |   | — |   | 80 |   |
| Loans  receivable (2)                                                       |   | (46                                               | )      | (456 | ) | (502 | ) |
| Total  interest-earning assets                                              |   | 229                                               |   | (564 | ) | (335 | ) |
|                                                                        |   |                                              |   |   |   |   |   |
| Interest  Expense:                                                          |   |                                              |   |   |   |   |   |
| Interest-bearing  deposits:                                                 |   |                                              |   |   |   |   |   |
| Demand                                                                      |   | $                                                 | 11     |   | $ | (64 | ) | $ | (53 | ) |
| Money  market and savings                                                   |   | 75                                                |   | (284 | ) | (209 | ) |
| Time  certificates of deposit:                                              |   |                                              |   |   |   |   |   |
| $100,000  or more                                                           |   | (72                                               | )      | (37 | ) | (109 | ) |
| Under  $100,000                                                             |   | (138                                              | )      | (163 | ) | (301 | ) |
| Total  time certificates of deposit                                         |   | (210                                              | )      | (200 | ) | (410 | ) |
| Total  interest-bearing deposits                                            |   | (124                                              | )      | (548 | ) | (672 | ) |
| Other  borrowings                                                           |   | 36                                                |   | (43 | ) | (7 | ) |
| Junior  subordinated debentures                                             |   | 454                                               |   | — |   | 454 |   |
| Federal  funds purchased and securities sold under agreements to repurchase |   | (9                                                | )      | — |   | (9 | ) |
| Total  interest-bearing liabilities                                         |   | 357                                               |   | (591 | ) | (234 | ) |
|                                                                        |   |                                              |   |   |   |   |   |
| Net  interest income                                                        |   | $                                                 | (128   | ) | $ | 27 |   | $ | (101 | ) |

 

----

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

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

 

18

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PROVISION FOR CREDIT LOSSES

 

There was no provision for credit losses for the threemonths and six months ended June 30, 2004 compared to a provision of $1.1million and $1.3 million for the three months and six months endedJune 30, 2003, respectively. The decrease in provisions for credit lossesfor the three months and six months ended June 30, 2004 was due torecoveries of loans previously charged off and the current adequacy of theallowance for credit losses based upon our analysis.  See Note 4 of Notes to Consolidated Financial Statements.

 

OTHER OPERATING INCOME

 

Other operating income increased to $402,000 duringthe second quarter of 2004 from $284,000 during the second quarter of 2003primarily due to an increase in deposit-related and other customer serviceincome due to increased fees and new product introduction.  Additionally, the 2003 period included a$61,000 loss on sale of OREO.

 

Other operating income increased to $867,000 duringthe six months ended June 30, 2004 from $719,000 during the six monthsended June 30, 2003 likewise due to an increase in deposit-related andother customer service income and the 2003 loss on sale of OREO.   The increase was partially offset by a$81,000 decrease in net gain on sale of securities available-for-sale anddecline in investment services income.

 

Net gains on sales of securities are generatedprimarily in declining interest rate environments.   Accordingly, gains or losses from sales of securities mayfluctuate significantly from period to period, and the results in any periodare not necessarily indicative of the results which may be obtained in futureperiods.

 

OTHER OPERATING EXPENSES

 

Other operating expenses were nearly unchanged at $3.4million for the three months ended June 30, 2004 and 2003. Varianceswithin operating expenses were reflected as follows: (i) salaries and relatedbenefits expense increased $44,000 or 2.4%; (ii) net occupancy expensedecreased $20,000 or 5.8%; (iii) premise and equipment expense increased$37,000 or 29.6%; (iv) computer data processing expense decreased $25,000 or10.0%;  (v) legal services expensedecreased $39,000 or 33.3%;  (vi)retirement of premises and equipment increased $43,000; and (vii) promotionaland other expenses decreased $60,000 or 44.4%.

 

19

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Other operating expenses were nearly unchanged at $6.9million for the six months ended June 30, 2004 compared to $6.8 millionfor the same period in 2003. Variances within operating expenses were reflectedas follows; (i) salaries and related benefits expense increased $85,000 or2.3%; (ii) net occupancy expense decreased $58,000 or 8.6%; (iii) premise andequipment expense increased $64,000 or 27.4%; (iv) client services expensedecreased $40,000, or 12.58%; (v) legal services expense decreased $79,000 or30.4%;  and (vii) retirement of premisesand equipment increased $43,000.

 

The increase in salary and related expense isprimarily due to the addition of business development staff and increasedcommission expense. The decrease in occupancy expense was due to a decrease inrent expense from the move of the corporate headquarters in January 2004.The increase in premise and equipment expense is due to an increase inmaintenance and repairs of computers primarily due to the temporary moves ofthe corporate headquarters and the Beverly Hills loan production office.  Legal expenses decreased for the collectionof loans due to fewer past due loans and fewer other real estate ownedproperties.

 

MINORITY INTEREST IN THE COMPANY’S INCOME

 

The minority interest in the Company’s income of theguaranteed beneficial interest in the Company’s Junior Subordinated Debentureswas $456,000 for the six months ended June 30, 2003.  As a result of the reclassification pursuantto FIN 46 effective July 1, 2003, no such minority interest expense wasrecorded for the six months ended June 30, 2004.

 

***BALANCE SHEETANALYSIS***

 

INVESTMENT SECURITIES

 

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

 

20

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**Estimated Fair Values of and Unrealized**

**Gains and Losses on Securities**

 
|                                                                      |   | **June 30,  2004**     |   |
|---------------------------------------------------------------------------|--------|-----------------------------|--------|
|                                                                      |   | **Total  amortized  cost**  |   | **Gross  unrealized  gains** |   | **Gross  unrealized  loss** |   | **Estimated  fair  value** |   |
|                                                                      |   | **(Dollars  in thousands)** |   |
| **Available-for-Sale:**                                                   |   |                        |   |   |   |   |   |   |   |
| U.S. Treasury securities                                                  |   | $                           | 703    |   | $ | — |   | $ | 2 |   | $ | 701 |   |
| GNMA-issued/guaranteed mortgage pass through  certificates                |   | 233                         |   | 9 |   | — |   | 242 |   |
| Other U.S. Government and federal agency  securities                      |   | 32,119                      |   | — |   | 161 |   | 31,958 |   |
| FHLMC/FNMA-issued mortgage pass through  certificates                     |   | 4,054                       |   | 118 |   | — |   | 4,172 |   |
| CMO’s and REMIC’s issued by U.S.  government-sponsored agencies |   | 46                          |   | — |   | — |   | 46 |   |
| Mutual funds                                                              |   | 10,000                      |   | — |   | 192 |   | 9,808 |   |
| Privately issued corporate bonds, CMO and  REMIC securities               |   | 957                         |   | 3 |   | — |   | 960 |   |
|                                                                      |   | $                           | 48,112 |   | $ | 130 |   | $ | 355 |   | $ | 47,887 |   |
|                                                                      |   |                        |   |   |   |   |   |   |   |
| FRB and other equity stocks                                               |   | $                           | 2,746  |   | — |   | 17 |   | $ | 2,729 |   |

 
|                                                  |   | **June 30, 2004**     |   |
|-------------------------------------------------------|--------|----------------------------|--------|
|                                                  |   | **Total  amortized  cost** |   | **Gross  unrealized  gains** |   | **Gross  unrealized  loss** |   | **Estimated  fair  value** |   |
|                                                  |   | **(Dollars in thousands)** |
| **Held-to-Maturity:**                                 |   |                       |   |   |   |   |   |   |   |
| FHLMC/FNMA-issued mortgage pass through  certificates |   | $                          | 4,025  |   | $ | 10 |   | $ | 17 |   | $ | 4,018 |   |
|                                                  |   | $                          | 4,025  |   | $ | 10 |   | $ | 17 |   | $ | 4,018 |   |

 
|                                                                      |   | **December 31, 2003** |   |
|---------------------------------------------------------------------------|--------|----------------------------|--------|
|                                                                      |   | **Total  amortized  cost** |   | **Gross  unrealized  gains** |   | **Gross  unrealized  loss** |   | **Estimated  fair  value** |   |
|                                                                      |   | **(Dollars in thousands)** |   |
| **Available-For-Sale:**                                                   |   |                       |   |   |   |   |   |   |   |
| U.S. Treasury securities                                                  |   | $                          | 600    |   | $ | — |   | $ | 1 |   | $ | 599 |   |
| GNMA-issued/guaranteed mortgage pass  through certificates                |   | 351                        |   | 12 |   | — |   | 363 |   |
| Other U.S. government and federal agency  securities                      |   | 12,758                     |   | 45 |   | 4 |   | 12,799 |   |
| FHLMC/FNMA-issued mortgage pass through  certificates                     |   | 3,828                      |   | 161 |   | — |   | 3,989 |   |
| CMO’s and REMIC’s issued by U.S.  government-sponsored agencies |   | 56                         |   | 1 |   | — |   | 57 |   |
| Mortgage mutual funds                                                     |   | 10,000                     |   | — |   | 98 |   | 9,902 |   |
| Privately issued corporate bonds, CMO and  REMIC securities               |   | 3,163                      |   | 5 |   | — |   | 3,168 |   |
|                                                                      |   | $                          | 30,756 |   | $ | 224 |   | $ | 103 |   | $ | 30,877 |   |
|                                                                      |   |                       |   |   |   |   |   |   |   |
| FRB and other equity stocks                                               |   | $                          | 1,872  |   | — |   | — |   | $ | 1,872 |   |

 
|                                                  |   | **December 31, 2003** |   |
|-------------------------------------------------------|--------|----------------------------|--------|
|                                                  |   | **Total  amortized  cost** |   | **Gross  unrealized  gains** |   | **Gross  unrealized  loss** |   | **Estimated  fair  value** |   |
|                                                  |   | **(Dollars in thousands)** |   |
|                                                  |   |                       |   |   |   |   |   |   |   |
| **Held-to-Maturity:**                                 |   |                       |   |   |   |   |   |   |   |
| FHLMC/FNMA-issued mortgage pass through  certificates |   | $                          | 4,597  |   | $ | 43 |   | $ | — |   | $ | 4,640 |   |
|                                                  |   |                       |   |   |   |   |   |   |   |
|                                                  |   | $                          | 4,597  |   | $ | 43 |   | $ | — |   | $ | 4,640 |   |

 

21

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As of June 30, 2004, the Company did not holdsecurities of any issuer, other than U.S. government agencies and corporations,the aggregate book value of which exceeded 10% of the Company’s shareholders’equity, except $9.8 million of an adjustable rate mortgage mutual fund in whichthe fund’s holdings are primarily comprised of U.S. agency securities, agencymortgage pools and U.S. Treasury securities. The Company had $4.0 million and $4.6 million securities classified asheld-to-maturity at June 30, 2004 and December 31, 2003, respectively.

 

LOAN PORTFOLIO

 

The following comparative period-end table sets forthcertain information concerning the composition of the loan portfolio.

 

**Loan Portfolio Composition**

 
|                                                                  |   | **June 30,  2004**     |    | **December 31,  2003** |   |
|-----------------------------------------------------------------------|--------|-----------------------------|---------|-----------------------------|--------|
|                                                                  |   | **Amount**                  |    | **Percent**                 |   | **Amount** |   | **Percent** |   |
|                                                                  |   | **(Dollars  in thousands)** |    |
| Real estate loans:                                                    |   |                        |    |                        |   |   |   |   |   |
| Secured by one to four family residential  properties                 |   | $                           | 7,630   |                        | 3      | % | $ | 8,167 |   | 3 | % |
| Secured by multifamily residential  properties                        |   | 12,536                      |    | 4                           | %      | 13,071 |   | 5 | % |
| Secured by commercial real properties                                 |   | 145,031                     |    | 50                          | %      | 132,320 |   | 52 | % |
| Real estate construction and land  development                        |   | 37,053                      |    | 13                          | %      | 27,210 |   | 10 | % |
| Commercial loans - secured and unsecured                              |   | 82,293                      |    | 29                          | %      | 76,699 |   | 29 | % |
| Consumer installment, home equity and  unsecured loans to individuals |   | 1,864                       |    | 1                           | %      | 3,510 |   | 1 | % |
| Total loans outstanding                                               |   | 286,407                     |    | 100                         | %      | 260,977 |   | 100 | % |
|                                                                  |   |                        |    |                        |   |   |   |   |   |
| Deferred net loan origination fees and  purchased loan discount       |   | (822                        | )       |                        |   | (728 | ) |   |   |
| Loans receivable, net                                                 |   | $                           | 285,585 |                        |   |   | $ | 260,249 |   |   |   |

 

Total loans outstanding increased by $25.3 million to$285.6 million at June 30, 2004 compared to $260.2 million atDecember 31, 2003 due to new originations in real estate loans secured bycommercial real properties and commercial loans resulting from additionalresources expended on business development. Additionally, newly originated as well as funding of previouslyoriginated real estate construction and land development loans contributed tothe 2004 loan growth.  Due to the

 

22

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nature of construction loans, the outstanding balance of newlyoriginated loans increases gradually during the life of the loan and repays ina lump sum.

 

NONPERFORMING ASSETS

 

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

 

**Nonperforming Assets**

 
|                                                                                                                       |   | **June 30,  2004**     |   | **December 31  2003** |   |
|----------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|--------|----------------------------|--------|
|                                                                                                                       |   | **(Dollars  in thousands)** |   |
|                                                                                                                       |   |                        |   |                       |   |
| Nonaccrual loans                                                                                                           |   | $                           | 289    |                       | $      | 438 |   |
| Troubled debt restructurings                                                                                               |   | —                      |   | —                     |   |
| Loans contractually past due ninety or more  days with respect to either principal or interest and still accruing interest |   | 6                           |   | —                     |   |
| Nonperforming loans                                                                                                        |   | 295                         |   | 438                        |   |
| Other real estate owned                                                                                                    |   | 1,010                       |   | 925                        |   |
| Other nonperforming assets                                                                                                 |   | —                      |   | —                     |   |
| Total nonperforming assets                                                                                                 |   | $                           | 1,305  |                       | $      | 1,363 |   |
|                                                                                                                       |   |                        |   |                       |   |
| Allowance for credit losses as a percent of  nonaccrual loans                                                              |   | 1277.2                      | %      | 829.9                      | %      |
| Allowance for credit losses as a percent of  nonperforming loans                                                           |   | 1251.2                      | %      | 829.9                      | %      |
| Total nonperforming assets as a percent of  loans receivable                                                               |   | 0.5                         | %      | 0.5                        | %      |
| Total nonperforming assets as a percent of  total shareholders’ equity                                                |   | 4.0                         | %      | 4.3                        | %      |

 

Nonaccrual loans decreased $149,000 fromDecember 31, 2003 to June 30, 2004 due primarily to collection ofnonaccrual loans and loan charge offs. Other real estate owned (OREO) increased $85,000 from December 31,2003 to June 30, 2004  due tocapitalization of expenditures for improvements on existing OREO.  Nonaccrual and impaired loans are accountedfor under the Company’s policy, which is in accordance with FinancialAccounting Standards No. 114 Accounting by Creditors for Impairment of a Loan.

 

ALLOWANCE FOR CREDITLOSSES

 

Provisions for credit losses charged to operationsreflect management’s judgment of the adequacy of the allowance for creditlosses and are determined through periodic analysis of the loan portfolio.  This analysis includes a detailed review ofthe classification and categorization of problem loans and loans to be chargedoff; an assessment of the overall quality and

 

23

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collectibility of the portfolio; and consideration of the loan lossexperience, trends in problem loan concentrations of credit risk, as well ascurrent and expected future economic conditions (particularly SouthernCalifornia). Management, in conjunction****with an outsideadvisory firm, performs a periodic risk and credit analysis, the results ofwhich are reported to the Board of Directors.

 

No loans were charged off during the second quarter of2004.  Loans charged off during the sixmonths ended June 30, 2004 were $35,000.  This compares to loans charged off of $2.4 million and $2.8million during the second quarter and first half of 2003, respectively.  Recoveries of loans previously charged offwere $58,000 and $91,000 during the second quarter and first half of 2004, respectively,compared to $54,000 and $194,000 during the second quarter and first half of2003, respectively.  See Note 4 of Notesto Consolidated Financial Statements.

 

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

 

DEPOSITS

 

Total deposits were $322.0 million and $298.7 millionat June 30, 2004 and December 31, 2003, respectively.  Noninterest-bearing demand deposits andmoney market deposits were $123.9 million and $80.0 million, respectively, atJune 30, 2004 compared to $120.0 million and $55.4 million, respectively,at December 31, 2003. Interest-bearing demand deposits, which are largelylimited to individuals, increased to $30.6 million at June 30, 2004 from$29.3 million at December 31, 2003. The increase in these accounts is attributable to an emphasis on growingbusiness banking through the hiring of commercial lending officers, whichgenerates transaction deposit accounts. Time certificates of deposit (“TCDs”) decreased to $49.8 million atJune 30, 2004 from $55.0 million at December 31, 2003 due to acontinued emphasis on growing lower cost transaction accounts and pricing TCD’sat rates designed to encourage run-off at maturity. There were no brokered TCDsat June 30, 2004 and $5.0 million brokered TCDs at December 31, 2003.

 

24

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FEDERAL FUNDSPURCHASED AND SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE

 

There were no federal funds purchased and securitiessold under agreements to repurchase at June 30, 2004 compared to $399,000at December 31, 2003.

 

OTHER BORROWINGS

 

Otherborrowings were $16.4 million at June 30, 2004 compared to $7.5 million atDecember 31, 2003 representing advances from the Federal Home LoanBank.   As part of its current fundingstrategy the Company utilized a greater amount of overnight borrowing from theFHLB to fund its securities available-for-sale and loans receivable.

 

JUNIORSUBORDINATED DEFERRABLE INTEREST DEBENTURES

 

JuniorSubordinated Debentures were $15.5 million at June 30, 2004 andDecember 31, 2003. See Note 9 of Notes to Consolidated FinancialStatements.

 

SHAREHOLDERS’EQUITY

 

Shareholders’ equity increased from $31.7 million atDecember 31, 2003 to $32.2 million at June 30, 2004 due to theretained earnings for the six months ended June 30, 2004 partially offsetby the decreases in market value of securities available-for-sale.

 

***CAPITAL ADEQUACY REQUIREMENTS***

 

At June 30, 2004 the Company and the Banks werein compliance with all applicable regulatory capital requirements and the Bankswere “well capitalized” under the Prompt Corrective Action rules of theOCC.  The following table sets forth theregulatory capital standards for well-capitalized institutions, and the capitalratios for the Company and the Banks as of June 30, 2004 andDecember 31, 2003.

 

25

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**Regulatory Capital Information**

**of the National Mercantile Bancorp and Banks**

 
|                              |   | **Minimum  For Capital  Adequacy  Purposes** |   | **Well  Capitalized  Standards** |   | **June 30,  2004** |   | **December 31,  2003** |   |
|-----------------------------------|--------|----------------------------------------------|--------|----------------------------------|--------|-------------------------|--------|-----------------------------|--------|
| **National Mercantile  Bancorp:** |   |                                         |   |                             |   |                    |   |                        |   |
| Tier 1 leverage                   |   | 4.00                                         | %      | N/A                              |   | 8.92                    | %      | 8.69                        | %      |
| Tier 1 risk-based capital         |   | 4.00                                         | %      | N/A                              |   | 10.41                   | %      | 11.02                       | %      |
| Total risk-based capital          |   | 8.00                                         | %      | N/A                              |   | 12.97                   | %      | 13.84                       | %      |
|                              |   |                                         |   |                             |   |                    |   |                        |   |
| **Mercantile National  Bank:**    |   |                                         |   |                             |   |                    |   |                        |   |
| Tier 1 leverage                   |   | 4.00                                         | %      | 5.00                             | %      | 7.84                    | %      | 8.13                        | %      |
| Tier 1 risk-based capital         |   | 4.00                                         | %      | 6.00                             | %      | 10.19                   | %      | 10.88                       | %      |
| Total risk-based capital          |   | 8.00                                         | %      | 10.00                            | %      | 11.44                   | %      | 12.13                       | %      |
|                              |   |                                         |   |                             |   |                    |   |                        |   |
| **South Bay Bank, NA:**           |   |                                         |   |                             |   |                    |   |                        |   |
| Tier 1 leverage                   |   | 4.00                                         | %      | 5.00                             | %      | 9.64                    | %      | 9.44                        | %      |
| Tier 1 risk-based capital         |   | 4.00                                         | %      | 6.00                             | %      | 10.13                   | %      | 11.18                       | %      |
| Total risk-based capital          |   | 8.00                                         | %      | 10.00                            | %      | 11.18                   | %      | 12.37                       | %      |

*** ***

***LIQUIDITY***

*** ***

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

 

The Company’s cash and due from banks was $22.0million on June 30, 2004 compared to $24.6 million on December 31,2003.  Due from banks-interest-bearingwas $2.7 million and $4.7 million at June 30, 2004 and December 31,2003, respectively.  Federal funds soldwere $4.0 million and $10.0 million for June 30, 2004 andDecember 31, 2003, respectively. Mercantile had $5.0 million and South Bay had $12.0 million in Federalfunds lines with correspondent banks as of June 30, 2004.

 

National Mercantile is a legal entity separate anddistinct 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 JuniorSubordinated Debentures.  Thesemi-annual interest payments on the Junior Subordinated Debentures, under theterms of the indenture, are deferrable at National Mercantile’s option, for aperiod up to ten consecutive semi-annual payments, but in any event not beyondJune 25, 2031.  The NationalMercantile has not deferred any interest payments.

 

26

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National Mercantile’s cash and due from banks was $1.0million on June 30, 2004 compared to $1.2 million at December 31,2003.

 

Dividends and capital distributions from the Banksconstitute the principal ongoing source of cash to National Mercantile.  The Banks are subject to various statutoryand regulatory restrictions on their ability to pay dividends and capitaldistributions to National Mercantile.

 

OCC approval is required for a national bank to pay adividend if the total of all dividends declared in any calendar year exceedsthe total of the bank’s net profits (as defined) for that year combined withits retained net profits for the preceding two calendar years, less anyrequired transfer to surplus or a fund for the retirement of any preferred stock.  A national bank may not pay any dividendthat exceeds its retained net earnings, as defined by the OCC.  The OCC and the Federal Reserve have alsoissued banking circulars emphasizing that the level of cash dividends shouldbear a direct correlation to the level of a national bank’s current andexpected earnings stream, the bank’s need to maintain an adequate capital baseand other factors.

 

National banks that are not in compliance withregulatory capital requirements generally are not permitted to pay dividends.  The OCC also can prohibit a national bankfrom engaging in an unsafe or unsound practice in its business.  Depending on the bank’s financial condition,payment of dividends could be deemed to constitute an unsafe or unsoundpractice.  Except under certaincircumstances, and with prior regulatory approval, a bank may not pay adividend if, after so doing, it would be undercapitalized.  A bank’s ability to pay dividends in thefuture is, and could be, further influenced by regulatory policies or agreementsand by capital guidelines.

 

Mercantile has a substantial accumulated deficit anddoes not anticipate having positive retained earnings for the foreseeablefuture.  South Bay has an accumulatedsurplus of $477,000 as of June 30, 2004. Mercantile and South Bay may from time to time be permitted to makecapital distributions to National Mercantile with the consent of the OCC.  It is not anticipated that such consentcould be obtained unless the distributing bank were to remain “wellcapitalized” following such distribution.

 

***ASSET LIABILITYMANAGEMENT***

*** ***

The following table shows that the Company’scumulative one-year interest rate sensitivity gap indicated an asset sensitiveposition of $67.6 million at June 30, 2004, a $18.3 million decrease froman asset sensitive position of $85.9 million

 

27

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at December 31, 2003.  Thischange resulted primarily from an increase in demand, money market and savingsdeposits repricing in less than three months, partially offset by an increasein adjustable loans receivable and federal funds sold.

 

The Company’s asset sensitive position during a periodof slowly declining interest rates is not expected to have a significantnegative impact on net interest income since rates paid on the Company’s largebase of interest bearing demand, savings and money market deposits historicallyhave not changed proportionately with changes in interest rates.  However, since the Company is in an assetsensitive position, in a period of rapidly declining rates, such as theenvironment that was experienced during 2001 and 2002, the rapid decline willhave a negative effect on the Company’s net interest income as changes in therates of interest bearing deposits historically have not changed in similarmagnitude to changes in market interest rates. Additionally, in relatively low and declining interest rateenvironments, the interest rates paid on funding liabilities may begin to reachfloors preventing further downward adjustments while rates on earning assetscontinue to adjust downward.

 

28

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**Rate-Sensitive Assets and Liabilities**

 
|                                                                     |   | **June 30,  2004**       |
|--------------------------------------------------------------------------|--------|-------------------------------|
|                                                                     |   | **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  |   | $                             | 4,000 |   | $ | — |   | $ | — |   | $ | — |   | $ | 4,000 |   |
| Securities at amortized cost                                             |   | 10,768                        |   | 2,021 |   | 25,456 |   | 13,667 |   | 51,912 |   |
| Due from banks - interest bearing                                        |   | —                        |   | 2,728 |   | — |   | — |   | 2,728 |   |
| FRB and other stock, at cost                                             |   | —                        |   | — |   | — |   | 2,746 |   | 2,746 |   |
| Loans receivable (1)                                                     |   | 245,298                       |   | 9,523 |   | 20,913 |   | 9,562 |   | 285,296 |   |
| Total rate-sensitive assets                                              |   | 260,066                       |   | 14,272 |   | 46,369 |   | 25,975 |   | 346,682 |   |
|                                                                     |   |                          |   |   |   |   |   |   |   |   |   |
| Rate-Sensitive Liabilities:  (2)                                    |   |                          |   |   |   |   |   |   |   |   |   |
| Interest bearing deposits:                                               |   |                          |   |   |   |   |   |   |   |   |   |
| Demand, money market and savings                                         |   | 148,287                       |   | — |   | — |   | — |   | 148,287 |   |
| Time certificates of deposit                                             |   | 14,985                        |   | 27,064 |   | 7,646 |   | 86 |   | 49,781 |   |
| Other borrowings                                                         |   | 5,000                         |   | 11,400 |   |   |   | — |   | 16,400 |   |
| Total rate-sensitive liabilities                                         |   | 168,272                       |   | 38,464 |   | 7,646 |   | 86 |   | 214,468 |   |
| Interest rate-sensitivity gap                                            |   | 91,794                        |   | (24,192 | ) | 38,723 |   | 25,889 |   | 132,214 |   |
| Cumulative interest rate-sensitivity gap                                 |   | $                             | 91,794 |   | $ | 67,602 |   | $ | 106,325 |   | $ | 132,214 |   |   |   |
| Cumulative ratio of rate sensitive assets  to rate-sensitive liabilities |   | 155                           | % | 133 | % | 150 | % | 162 | % |   |   |
|                                                                          |        |                               |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1) Loans receivable excludes nonaccrualloans.

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

  The distribution of other timedeposits is based on scheduled maturities.

 

29

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|                                                                     |   | **December 31,  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  |   | $                             | 10,000 |   | $ | — |   | $ | — |   | $ | — |   | $ | 10,000 |   |
| Securities available-for-sale, at amortized  cost                        |   | 10,507                        |   | 4,186 |   | 4,875 |   | 11,309 |   | 30,877 |   |
| Securities held-to-maturity                                              |   | —                        |   | — |   | — |   | 4,597 |   | 4,597 |   |
| Due from banks - interest bearing                                        |   | —                        |   | 4,728 |   | — |   | — |   | 4,728 |   |
| FRB and other stock, at cost                                             |   | —                        |   | — |   | — |   | 1,872 |   | 1,872 |   |
| Loans receivable (1)                                                     |   | 221,578                       |   | 6,647 |   | 27,973 |   | 4,341 |   | 260,539 |   |
| Total rate-sensitive assets                                              |   | 242,085                       |   | 15,561 |   | 32,848 |   | 22,119 |   | 312,613 |   |
|                                                                     |   |                          |   |   |   |   |   |   |   |   |   |
| Rate-Sensitive Liabilities:  (2)                                    |   |                          |   |   |   |   |   |   |   |   |   |
| Interest bearing deposits:                                               |   |                          |   |   |   |   |   |   |   |   |   |
| Demand, money market and savings                                         |   | 123,696                       |   | — |   | — |   | — |   | 123,696 |   |
| Time certificates of deposit                                             |   | 28,427                        |   | 19,263 |   | 7,333 |   | — |   | 55,023 |   |
| Other borrowings                                                         |   | —                        |   | 399 |   | — |   | — |   | 399 |   |
| Total rate-sensitive liabilities                                         |   | 152,123                       |   | 19,662 |   | 7,333 |   | — |   | 179,118 |   |
| Interest rate-sensitivity gap                                            |   | 89,962                        |   | (4,101 | ) | 25,515 |   | 22,119 |   | 133,495 |   |
| Cumulative interest rate-sensitivity gap                                 |   | $                             | 89,962 |   | $ | 85,861 |   | $ | 111,376 |   | $ | 133,495 |   |   |   |
| Cumulative ratio of rate sensitive assets  to rate-sensitive liabilities |   | 159                           | %      | 150 | % | 162 | % | 175 | % |   |   |
|                                                                          |        |                               |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1) Loans receivable excludes nonaccrualloans.

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

  The distribution of other timedeposits is based on scheduled maturities.

 

30

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# **FACTORSWHICH MAY AFFECT FUTURE OPERATING RESULTS**

# ** **

Our results of operations and financial condition areaffected by many factors, including the following.

 

**We face risk from changesin interest rates.**

 

The success of our business depends, to a largeextent, on our net interest income. Changes in market interest rates can affect our net interest income byaffecting the spread between our interest-earning assets and interest-bearingliabilities.  This may be due to thedifferent maturities of our interest-earning assets and interest-bearingliabilities, as well as an increase in the general level of interestrates.  Changes in market interest ratesalso affect, among other things:

 

•                  Our ability to originate loans;

 

•                  The ability of our borrowers to makepayments on their loans;

 

•                  The value of our interest-earningassets and our ability to realize gains from the sale of these assets;

 

•                  The average life of ourinterest-earning assets;

 

•                  Our ability to generate depositsinstead of other available funding alternatives; and

 

•                  Our ability to access the wholesalefunding market.

 

Interest rates are highly sensitive to many factors,including governmental monetary policies, domestic and international economicand political conditions and other factors beyond our control.

 

**We face risk from possibledeclines in the quality of our assets.**

 

Our financial condition depends significantly on thequality of our assets.  While we havedeveloped and implemented underwriting policies and procedures to guide us inthe making of loans, compliance with these policies and procedures in makingloans does not guarantee repayment of the loans.  If the level of our non-performing assets rises, our results ofoperations and financial condition will be affected.  A borrower’s ability to pay its loan in accordance with its termscan be adversely affected by a number of factors, such as a decrease in theborrower’s revenues and cash flows due to adverse changes in economicconditions or a decline in the demand for the borrower’s products and/orservices.

 

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

 

We establish allowances for credit losses against eachsegment of our loan portfolio.  AtJune 30, 2004, our allowance for credit losses equaled 1.29% of loansreceivable and 1,251% of nonperforming loans. Although we believed that we had established adequate allowances forcredit losses as of June 30, 2004, the credit quality of our assets isaffected by many factors beyond our control, including local and nationaleconomic conditions, and the possible existence of facts which are not

 

31

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known to us which adversely affect the likelihood of repayment ofvarious loans in our loan portfolio and realization of the collateral upon adefault.  Accordingly, we can give noassurance that we will not sustain loan losses materially in excess of theallowance for credit losses.  Inaddition, the Office of the Comptroller of the Currency, as an integral part ofits examination process, periodically reviews our allowance for credit lossesand could require additional provisions for credit losses.  Material future additions to the allowancefor credit losses may also be necessary due to increases in the size andchanges in the composition of our loan portfolio.  Increases in our provisions for credit losses would adverselyaffect our results of operations.

 

**Economic conditions may worsen.**

 

Our business is strongly influenced by economicconditions 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 significantamount of the loans we make are to borrowers in California, our operationscould suffer as a result of local recession or natural disasters in California.**

 

At June 30, 2004, a large majority of our loansoutstanding were collateralized by real properties located in California.  Because of this concentration in California,our financial position and results of operations have been and are expected tocontinue to be influenced by general trends in the California economy and itsreal estate market.  Real estate marketdeclines may adversely affect the values of the properties collateralizingloans.  If the principal balances of ourloans, together with any primary financing on the mortgaged properties, equalor exceed the value of the mortgaged properties, we could incur higher losseson sales of properties collateralizing foreclosed loans.  In addition, California historically hasbeen vulnerable to certain natural disaster risks, such as earthquakes and erosion-causedmudslides, which are not typically covered by the standard hazard insurancepolicies maintained by borrowers. Uninsured disasters may adversely impact our ability to recover losseson properties affected by such disasters and adversely impact our results ofoperations.

 

**Our business is verycompetitive.**

 

There is intense competition in Southern Californiaand elsewhere in the United States for banking customers.  We experience competition for deposits frommany sources, including credit unions, insurance companies and money market andother mutual funds, as well as other commercial banks and savingsinstitutions.  We compete for loans anddeposits primarily

 

32

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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 heavilyregulated.**

 

Both National Mercantile as a bank holding company,and Mercantile and South Bay, as national banks, are subject to significantgovernmental supervision and regulation, which is intended primarily for theprotection of depositors.  Statutes andregulations affecting us may be changed at any time, and the interpretation ofthese statutes and regulations by examining authorities also may change.  We cannot assure you that future changes inapplicable statutes and regulations or in their interpretation will notadversely affect our business.

 

**We test goodwill annually and must record anyimpairment as a charge to earnings**.

 

Statement of Financial Accounting Standards No. 142“Goodwill and Other Intangible Assets” (“SFAS No. 142”), among otherprovisions, prescribes that goodwill and intangible assets that have indefiniteuseful lives will not be amortized but rather tested annually, or morefrequently upon the occurrence of certain events, for impairment.  SFAS No. 142 provides specific guidance forthe testing of goodwill for impairment, which may require re-measurement of thefair value of the reporting unit. Impairment losses are to be reported as a charge to current periodearnings.

 

We recorded goodwill of $3.2 million in connectionwith the South Bay acquisition in December 2001.  During the fourth quarter of 2003, wecompleted the required impairment tests of goodwill.  The tests determined that our goodwill was not consideredimpaired.  No assurance can be giventhat our goodwill will not become impaired in the future.

 

**We determine annually whether our deferred tax assetwill be realized and must establish a valuation allowance if necessary toreduce it to its realizable value.**

 

On a periodic basis, at least annually, we perform ananalysis to determine if it is more likely than not that some or all of thegross deferred tax asset will not be realized. Factors used in the analysis that are reflective of the futurerealization of a deferred tax asset are:

 

33

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•                  Future earningsare assured;

 

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

 

A valuation allowance may be established to reduce the deferred taxasset to its realizable value.  Thedetermination of whether a valuation allowance is necessary involvesconsidering the positive and negative factors related to whether the deferredtax asset is more likely than not to be realized.  Any adjustment required to the valuation allowance is coupledwith a related entry to income tax expense. A charge to earnings will be made in the event that we determine that avaluation allowance to the deferred tax asset is necessary. No such valuationallowance exists at June 30, 2004.

 

CAUTIONARY NOTEREGARDING FORWARD-LOOKING STATEMENTS

 

Statementsin the Quarterly Report on Form 10-QSB under the caption “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” andelsewhere in this report are forward-looking and are based upon informationcurrently available to the Company.  TheCompany, through its officers, directors or employees, may also from time totime make oral forward-looking statements.  Any such statement is qualified by reference to these cautionarystatements.   In connection with the “safeharbor” provisions of the Private Securities Litigation Reform Act of 1995, theCompany is hereby identifying important factors that could cause actual resultsto differ materially from those contained in any forward-looking statement madeby or on behalf of the Company.  Manyimportant factors that could cause such a difference are described in theCompany’s Annual Report Form 10-KSB for the year ended December 31, 2003,under the caption “Factors, Which May Affect Future Operating Results.”

 

Unduereliance should not be placed on the Company’s forward-looking statementsbecause the matters they describe are subject to known and unknown risks,uncertainties and other unpredictable factors, many of which are beyond theCompany’s control.  The Company’s forward-lookingstatements speak only as of the date on which this report was filed with UnitedStated Securities and Exchange Commission. Over time, actual results, performance or achievements will likelydiffer from the anticipated results, performance or achievements that areexpressed or implied by the Company’s forward-looking statements, and suchdifference might be significant and materially adverse to the Company’sstockholders.

 

Allsubsequent written or oral forward-looking statements attributable to theCompany or persons acting on the Company’s behalf are expressly qualified bythe factors described above.   TheCompany assumes no obligation, and disclaims any obligation, to updateinformation contained in the Quarterly Report on Form 10-QSB, includingforward-looking

 

34

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statements, as aresult of facts, events or circumstances after the date of this report, exceptas required by law in the normal course of its public disclosure practices.

 

***ITEM 3. CONTROLSAND PROCEDURES***

*** ***

The Company’s management, with the participation ofthe Chief Executive Officer and Chief Financial Officer, has conducted anevaluation of the effectiveness of the Company’s disclosure controls andprocedures pursuant to Rule 13a-14 under the Securities Exchange Act of 1934,as amended, as of the end of the period covered by this report. Based on thatevaluation, the Chief Executive Officer and the Chief Financial Officer believethat the Company’s disclosure controls and procedures reasonably ensurethat information required to be disclosed by the Company in this quarterlyreport has been made known to them in a timely manner.

 

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

 

35

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**PART II—OTHERINFORMATION**

 

***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 OF SECURITY HOLDERS

*** ***

(a)          On April 22, 2004, the Company held itsannual meeting of shareholders.

 

(b)         At the annual meeting, the following directorswere elected:  Donald E. Benson, JosephN. Cohen, Robert E. Gibson, W. Douglas Hile, Antoinette Hubenette, M.D., ScottA. Montgomery, Dion G. Morrow, Carl R. Terzian and Robert E. Thomson.

 

(c)          The voting for election of directors islisted below.

 

Election of Directors

 
| **Name**                   |   | **Votes For** |   | **Votes  Withheld** |   |
|----------------------------|--------|---------------|--------|---------------------|--------|
|                       |   |          |   |                |   |
| Donald E. Benson           |   | 2,553,218     |   | 0                   |   |
|                       |   |          |   |                |   |
| Joseph N. Cohen            |   | 2,553,218     |   | 0                   |   |
|                       |   |          |   |                |   |
| Robert E. Gipson           |   | 2,553,218     |   | 0                   |   |
|                       |   |          |   |                |   |
| W. Douglas Hile            |   | 2,553,218     |   | 0                   |   |
|                       |   |          |   |                |   |
| Antoinette Hubenette, M.D. |   | 2,553,218     |   | 0                   |   |
|                       |   |          |   |                |   |
| Scott A. Montgomery        |   | 2,553,218     |   | 0                   |   |
|                       |   |          |   |                |   |
| Dion G. Morrow             |   | 2,553,218     |   | 0                   |   |
|                       |   |          |   |                |   |
| Carl R. Terzian            |   | 2,553,218     |   | 0                   |   |
|                       |   |          |   |                |   |
| Robert E. Thomson          |   | 2,553,218     |   | 0                   |   |

 

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

 

None.

 

36

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

 

(a) *Exhibits.*

 

31.1 Certification of Scott A. Montgomery ondisclosure controls.

31.2 Certification of David R. Brown ondisclosure controls.

32.1 Certification of Scott A. Montgomerypursuant to section 906 of the Sarbanes-Oxley Act of 2002

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

 

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

 

Form 8-K, (Item 5) including the Company’spress release regarding first quarter 2004 operating results was furnishedApril 22, 2004.

 

Form 8-K, (Item 5) including the Company’spress release regarding second quarter 2004 operating results was furnishedAugust 4, 2004.

 

**SIGNATURES**

 

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

 
|   |                  |   | **NATIONAL MERCANTILE BANCORP**                       |   |
|--------|-----------------------|--------|-------------------------------------------------------|--------|
|   |                  |   | (Registrant)                                          |
|   |                  |   |                                                  |
| DATE:  | August 16 , 2004 |   | /s/  SCOTT A. MONTGOMERY                    |   |
|   |                  |   | **Scott A. Montgomery**                               |
|   |                  |   | Chief Executive Officer                               |
|   |                  |   |                                                  |
| DATE:  | August 16, 2004  |   | /s/  DAVID R. BROWN                         |   |
|   |                  |   | **David R. Brown**                                    |
|   |                  |   | Principal Financial and Principal Accounting  Officer |
|        |                       |        |                                                       |        |  |

 

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