**UNITED STATES**

**SECURITIES 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 ended March 31, 2004**

 

o**Transitionreport under section 13 or 15(d) of the Securities Exchange Act of 1934****for the transition period from        to       .**

 

**Commission File Number 0-15982**

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

 

Check whether theissuer:  (1) filed all reports requiredto be filed by Section 13 or 15(d) of the Exchange Act of 1934 during the past12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.     ý  Yes  o  No

 

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

 

Check whether the registrant filed all documents and reports requiredto be filed by Section 12, 13 or 15(d) of the Exchange Act after thedistribution of securities under a plan confirmed by a court.     o  Yes     o  No

 

**APPLICABLEONLY TO CORPORATE ISSUERS:**

 

State the number of shares outstanding of each of the issuer’s classesof common equity, as of the latest practicable dat:  The number of shares of Common Stock, no par value, of the issueroutstanding as of May 12, 2004 was 2,910,403.

 

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

 

 

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PART I – FINANCIAL INFORMATION

 

*Item 1.  Financial Statements*

 

2

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**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

 
|                                                                                                                                                                                                  |   | **March 31,  2004**        |    | **December  31,  2003** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------|---------|-------------------------|--------|
|                                                                                                                                                                                                  |   | **(Unaudited)**            |    |                    |   |
|                                                                                                                                                                                                  |   | **(Dollars in thousands)** |    |
| ASSETS                                                                                                                                                                                                |   |                       |    |                    |   |
| Cash and due  from banks-demand                                                                                                                                                                       |   | $                          | 25,373  |                    | $      | 24,556 |   |
| Due from  banks-interest bearing                                                                                                                                                                      |   | 4,325                      |    | 4,728                   |   |
| Federal funds  sold and securities purchased under agreements to resell                                                                                                                               |   | 18,000                     |    | 10,000                  |   |
| Cash and cash  equivalents                                                                                                                                                                            |   | 47,698                     |    | 39,284                  |   |
| Securities  available-for-sale, at fair value; aggregate amortized cost of $36,030 and  $30,756 at March 31, 2004 and December 31, 2003, respectively                                                 |   | 36,182                     |    | 30,877                  |   |
| Securities  held-to-maturity, at amortized cost                                                                                                                                                       |   | 4,374                      |    | 4,597                   |   |
| FRB and other  stock, at cost                                                                                                                                                                         |   | 1,872                      |    | 1,872                   |   |
| Loans receivable                                                                                                                                                                                      |   | 265,079                    |    | 260,249                 |   |
| Allowance for  credit losses                                                                                                                                                                          |   | (3,633                     | )       | (3,635                  | )      |
| Net loans  receivable                                                                                                                                                                                 |   | 261,446                    |    | 256,614                 |   |
| Premises and  equipment, net                                                                                                                                                                          |   | 5,349                      |    | 5,444                   |   |
| Other real  estate owned                                                                                                                                                                              |   | 968                        |    | 925                     |   |
| Deferred tax  asset                                                                                                                                                                                   |   | 6,749                      |    | 6,950                   |   |
| Goodwill                                                                                                                                                                                              |   | 3,225                      |    | 3,225                   |   |
| Intangible  assets, net                                                                                                                                                                               |   | 1,798                      |    | 1,854                   |   |
| Accrued interest  receivable and other assets                                                                                                                                                         |   | 3,352                      |    | 3,564                   |   |
| Total assets                                                                                                                                                                                          |   | $                          | 373,013 |                    | $      | 355,206 |   |
|                                                                                                                                                                                                  |   |                       |    |                    |   |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY                                                                                                                                                            |   |                       |    |                    |   |
| Deposits:                                                                                                                                                                                             |   |                       |    |                    |   |
| Noninterest-bearing  demand                                                                                                                                                                           |   | $                          | 127,411 |                    | $      | 119,998 |   |
| Interest-bearing  demand                                                                                                                                                                              |   | 31,582                     |    | 29,349                  |   |
| Money market                                                                                                                                                                                          |   | 70,480                     |    | 55,422                  |   |
| Savings                                                                                                                                                                                               |   | 40,121                     |    | 38,925                  |   |
| Time  certificates of deposit:                                                                                                                                                                        |   |                       |    |                    |   |
| $100,000 or more                                                                                                                                                                                      |   | 26,378                     |    | 27,308                  |   |
| Under $100,000                                                                                                                                                                                        |   | 21,266                     |    | 27,715                  |   |
| Total deposits                                                                                                                                                                                        |   | 317,238                    |    | 298,717                 |   |
|                                                                                                                                                                                                  |   |                       |    |                    |   |
| Federal funds  purchased and securities sold under agreements to repurchase                                                                                                                           |   | —                     |    | 399                     |   |
| Other borrowings                                                                                                                                                                                      |   | 7,500                      |    | 7,500                   |   |
| Junior  subordinated deferrable interest debentures                                                                                                                                                   |   | 15,464                     |    | 15,464                  |   |
| Accrued interest  payable and other liabilities                                                                                                                                                       |   | 770                        |    | 1,405                   |   |
| Total  liabilities                                                                                                                                                                                    |   | 340,972                    |    | 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  March 31, 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 March 31, 2004 and  December 31, 2003                                      |   | 1,000                      |    | 1,000                   |   |
| Common stock, no  par value; authorized 10,000,000 shares; outstanding 2,900,553 shares and  2,772,279 shares at March 31, 2004 and December 31, 2003, respectively                                   |   | 39,131                     |    | 38,602                  |   |
| Accumulated  deficit                                                                                                                                                                                  |   | (13,621                    | )       | (13,911                 | )      |
| Accumulated  other comprehensive income                                                                                                                                                               |   | 89                         |    | 71                      |   |
| Total  shareholders’ equity                                                                                                                                                                      |   | 32,041                     |    | 31,721                  |   |
| Total  liabilities and shareholders’ equity                                                                                                                                                      |   | $                          | 373,013 |                    | $      | 355,206 |   |

 

See accompanying notes to consolidated financial statements.

 

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**NATIONALMERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

(Unaudited)

 
|                                                                                                                      |   | **For the  Three Months Ended  March 31,**          |   |
|---------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------|--------|
|                                                                                                                      |   | **2004**                                            |   | **2003** |   |
|                                                                                                                      |   | **(Dollars  in thousands,  except per share data)** |   |
| Interest income:                                                                                                          |   |                                                |   |   |   |
| Loans, including  fees                                                                                                    |   | $                                                   | 3,785  |   | $ | 4,117 |   |
| Securities                                                                                                                |   | 299                                                 |   | 250 |   |
| Due from banks -  interest bearing                                                                                        |   | 15                                                  |   | — |   |
| Federal funds  sold and securities purchased under agreements to resell                                                   |   | 42                                                  |   | 43 |   |
| Total interest  income                                                                                                    |   | 4,141                                               |   | 4,410 |   |
| Interest  expense:                                                                                                        |   |                                                |   |   |   |
| Interest-bearing  demand                                                                                                  |   | 17                                                  |   | 61 |   |
| Money market and  savings                                                                                                 |   | 163                                                 |   | 301 |   |
| Time  certificates of deposit:                                                                                            |   |                                                |   |   |   |
| $100,000 or more                                                                                                          |   | 83                                                  |   | 147 |   |
| Under $100,000                                                                                                            |   | 113                                                 |   | 282 |   |
| Total interest  expense on deposits                                                                                       |   | 376                                                 |   | 791 |   |
| Federal funds  purchased and securities sold under agreements to repurchase                                               |   | —                                              |   | 8 |   |
| Junior  subordinated deferrable interest debentures                                                                       |   | 226                                                 |   | — |   |
| Other borrowings                                                                                                          |   | 88                                                  |   | 89 |   |
| Total interest  expense                                                                                                   |   | 690                                                 |   | 888 |   |
| Net interest income  before provision for credit losses                                                                   |   | 3,451                                               |   | 3,522 |   |
| Provision for  credit losses                                                                                              |   | —                                              |   | 110 |   |
| Net interest  income after provision for credit losses                                                                    |   | 3,451                                               |   | 3,412 |   |
| Other operating  income:                                                                                                  |   |                                                |   |   |   |
| Net gain on sale  of securities available-for-sale                                                                        |   | 19                                                  |   | 100 |   |
| International  services                                                                                                   |   | 14                                                  |   | 8 |   |
| Investment  division                                                                                                      |   | 12                                                  |   | 22 |   |
| Deposit-related  and other customer services                                                                              |   | 420                                                 |   | 305 |   |
| Total other  operating income                                                                                             |   | 465                                                 |   | 435 |   |
| Other operating  expenses:                                                                                                |   |                                                |   |   |   |
| Salaries and  related benefits                                                                                            |   | 1,868                                               |   | 1,827 |   |
| Net occupancy                                                                                                             |   | 291                                                 |   | 329 |   |
| Furniture and  equipment                                                                                                  |   | 136                                                 |   | 109 |   |
| Printing and  communications                                                                                              |   | 133                                                 |   | 129 |   |
| Insurance and  regulatory assessments                                                                                     |   | 117                                                 |   | 111 |   |
| Client services                                                                                                           |   | 132                                                 |   | 178 |   |
| Computer data  processing                                                                                                 |   | 261                                                 |   | 216 |   |
| Legal services                                                                                                            |   | 103                                                 |   | 143 |   |
| Other  professional services                                                                                              |   | 182                                                 |   | 225 |   |
| Amortization of  core deposit intangible                                                                                  |   | 56                                                  |   | 56 |   |
| Retirement of  fixed assets and leasehold improvements                                                                    |   | 43                                                  |   | — |   |
| Promotion and  other expenses                                                                                             |   | 101                                                 |   | 87 |   |
| Total other  operating expenses                                                                                           |   | 3,423                                               |   | 3,410 |   |
| Income before  income tax provision and minority interest                                                                 |   | 493                                                 |   | 437 |   |
|                                                                                                                      |   |                                                |   |   |   |
| Minority  interest in the Company’s income of the:                                                                   |   |                                                |   |   |   |
| Guaranteed  preferred beneficial interests in the Company’s junior subordinated  deferrable interest debentures, net |   | —                                              |   | 233 |   |
|                                                                                                                      |   |                                                |   |   |   |
| Income before  income tax provision                                                                                       |   | 493                                                 |   | 204 |   |
|                                                                                                                      |   |                                                |   |   |   |
| Income tax  provision                                                                                                     |   | 202                                                 |   | 107 |   |
| Net income                                                                                                                |   | $                                                   | 291    |   | $ | 97 |   |
| Earnings per  share:                                                                                                      |   |                                                |   |   |   |
| Basic                                                                                                                     |   | $                                                   | 0.10   |   | $ | 0.04 |   |
| Diluted                                                                                                                   |   | $                                                   | 0.06   |   | $ | 0.02 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

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**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(Unaudited)

 
|                                                                                         |   | **For the  three Months Ended March 31,** |   |
|----------------------------------------------------------------------------------------------|--------|-------------------------------------------|--------|
|                                                                                         |   | **2004**                                  |   | **2003** |   |
|                                                                                         |   | **(Dollars  in thousands)**               |   |
| Cash flows from  operating activities:                                                       |   |                                      |   |   |   |
| Net income                                                                                   |   | $                                         | 291    |   | $ | 97 |   |
| Adjustments to  reconcile net income to net cash provided by (used in) operating activities: |   |                                      |   |   |   |
| Depreciation and  amortization                                                               |   | 158                                       |   | 143 |   |
| Provision for  credit losses                                                                 |   | —                                    |   | 110 |   |
| Gain on sale of  securities available for sale                                               |   | (19                                       | )      | (100 | ) |
| Net amortization  of premium on securities available-for-sale                                |   | 25                                        |   | 71 |   |
| Net amortization  of premium on securities held-to-maturity                                  |   | 13                                        |   | — |   |
| Net amortization  of core deposit intangible                                                 |   | 56                                        |   | 56 |   |
| Net amortization  of premium on loans purchased                                              |   | 50                                        |   | 72 |   |
| Decrease  (increase) in accrued interest receivable and other assets                         |   | 355                                       |   | (2,293 | ) |
| Decrease in  accrued interest payable and other liabilities                                  |   | (635                                      | )      | (1,213 | ) |
| Net cash  provided by (used in) operating activities                                         |   | 294                                       |   | (3,057 | ) |
| Cash flows from  investing activities:                                                       |   |                                      |   |   |   |
| Purchase of  securities available-for-sale                                                   |   | (8,607                                    | )      | (2,250 | ) |
| Proceeds from  sales of securities available-for-sale                                        |   | 2,019                                     |   | 2,757 |   |
| Proceeds from  repayments and maturities of securities available-for-sale                    |   | 1,309                                     |   | 7,512 |   |
| Proceeds from  repayments and maturities of securities held-to-maturity                      |   | 210                                       |   | — |   |
| Loan  originations and principal collections, net                                            |   | (4,882                                    | )      | 3,708 |   |
| Purchases of  premises and equipment                                                         |   | (63                                       | )      | (17 | ) |
| Net cash (used  in) provided by investing activities                                         |   | (10,014                                   | )      | 11,710 |   |
| Cash flows from  financing activities:                                                       |   |                                      |   |   |   |
| Net increase in  demand deposits, money market and savings accounts                          |   | 25,900                                    |   | 11,342 |   |
| Net decrease in  time certificates of deposit                                                |   | (7,379                                    | )      | (7,481 | ) |
| Net decrease in  securities sold under agreements to repurchase and federal funds purchased  |   | (399                                      | )      | (684 | ) |
| Net proceeds  from exercise of stock options                                                 |   | 12                                        |   | 33 |   |
| Net cash  provided by financing activities                                                   |   | 18,134                                    |   | 3,210 |   |
| Net increase in cash  and cash equivalents                                                   |   | 8,414                                     |   | 11,863 |   |
| Cash and cash  equivalents, January 1                                                        |   | 39,284                                    |   | 37,576 |   |
| Cash and cash  equivalents, March 31                                                         |   | $                                         | 47,698 |   | $ | 49,439 |   |
|                                                                                         |   |                                      |   |   |   |
| Supplemental  disclosures of cash flow information:                                          |   |                                      |   |   |   |
| Cash paid for  interest                                                                      |   | $                                         | 802    |   | $ | 1,400 |   |
| Transfers to  OREO from loans receivable, net                                                |   | —                                    |   | 535 |   |
| Cash paid for  income taxes, net                                                             |   | $                                         | 3      |   | $ | — |   |

 

See accompanying notes to consolidated financial statements.

 

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**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

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

 

NOTE 1—BASIS OF PRESENTATION AND MANAGEMENTREPRESENTATIONS

 

The unaudited consolidated financial statements include the accounts ofNational Mercantile Bancorp (the ‘‘Company’’) and its wholly ownedsubsidiaries, Mercantile National Bank and South Bay Bank, N.A.  The Company adopted FASB Interpretation No.46 Consolidation of Variable Interest Entities effective July 1, 2003 andaccordingly the accounts of National Mercantile Capital Trust I are notincluded in the consolidated balance sheet at March 31, 2004 or theconsolidated statement of operations for the three months then ended.   The unaudited consolidated financialstatements reflect all interim adjustments, which are of a normal recurringnature and which, in management’s opinion, are necessary for the fairpresentation of the Company’s consolidated financial position and results ofoperations and cash flows for such interim periods. The results for the threemonths ended March 31, 2004 are not necessarily indicative of the resultsexpected for any subsequent period or for the full year ending December 31,2004. The unaudited consolidated financial statements should be read inconjunction with the audited consolidated financial statements included in theCompany’s Annual Report on Form 10-KSB for the year ended December 31, 2003.

 

NOTE 2—EARNINGS PER SHARE

 

Basic earnings per share is computed using the weighted average numberof common shares outstanding during the period.  The weighted average number of common shares outstanding used incomputing basic earnings per share and diluted earnings per share for the threemonths ended March 31, 2004 was 2,810,522 and 4,664,397, respectively.  The weighted average number of common sharesoutstanding used in computing basic earnings per share for the three monthsended March 31, 2003 was 2,687,560.  Theweighted average number of common shares and common share equivalentsoutstanding used in computing diluted earnings per share for the three monthsended March 31, 2003 was 4,350,008.

 

The following table is a reconciliation of income and shares used inthe computation of basic and diluted loss per share:

 

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|                                          |   | **Earnings  available to  shareholders** |   | **Weighted  Average  Shares** |      | **Per share  amount** |   |
|-----------------------------------------------|--------|------------------------------------------|--------|-------------------------------|-----------|-----------------------|--------|
|                                          |   | **(in  thousands)**                      |   |                          |      |                  |   |
|                                          |   |                                     |   |                          |      |                  |   |
| *For  the three months ended March 31, 2004:* |   |                                     |   |                          |      |                  |   |
| Basic earnings  per share                     |   | $                                        | 291    |                          | 2,810,522 |                  | $      | 0.10 |   |
|                                          |   |                                     |   |                          |      |                  |   |
| Effect of  diultive securities:               |   |                                     |   |                          |      |                  |   |
| Options                                       |   |                                     |   | 351,563                       |      |                  |   |
| Convertible  preferred stock                  |   |                                     |   | 1,502,312                     |      |                  |   |
| Diluted earnings  per share                   |   | $                                        | 291    |                          | 4,664,397 |                  | $      | 0.06 |   |
|                                          |   |                                     |   |                          |      |                  |   |
| *For  the three months ended March 31, 2003:* |   |                                     |   |                          |      |                  |   |
| Basic earnings  per share                     |   | $                                        | 97     |                          | 2,687,560 |                  | $      | 0.04 |   |
|                                          |   |                                     |   |                          |      |                  |   |
| Effect of  diultive securities:               |   |                                     |   |                          |      |                  |   |
| Options                                       |   |                                     |   | 39,219                        |      |                  |   |
| Convertible  preferred stock                  |   |                                     |   | 1,623,229                     |      |                  |   |
| Diluted earnings  per share                   |   | $                                        | 97     |                          | 4,350,008 |                  | $      | 0.02 |   |

 

NOTE 3—CASH AND CASH EQUIVALENTS

 

For purposes of reporting cash flows, cash and cash equivalents includecash, due from banks-demand, due from banks-interest-bearing and federal fundssold.

 

NOTE 4—ALLOWANCE FOR CREDIT LOSSES

 

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

 

The following table sets forth information concerning the Company’sallowance for credit losses for the periods indicated.

 

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**Analysisof Changes in Allowance for Credit Losses**

 
|                                                                                  |   | **Three  months ended**     |   |
|---------------------------------------------------------------------------------------|--------|-----------------------------|--------|
|                                                                                  |   | **March 31,  2004**         |   | **March 31,  2003** |   |
|                                                                                  |   | **(Dollars  in thousands)** |   |
|                                                                                  |   |                        |   |   |   |
| Balance,  beginning of period                                                         |   | $                           | 3,635  |   | $ | 4,846 |   |
| Loans charged  off:                                                                   |   |                        |   |   |   |
| Real estate  loans:                                                                   |   |                        |   |   |   |
| Secured by one  to four family residential properties                                 |   | —                      |   | 23 |   |
| Secured by  multifamily residential properties                                        |   | —                      |   | — |   |
| Secured by  commercial real properties                                                |   | —                      |   | — |   |
| Real estate  construction and land development                                        |   | —                      |   | — |   |
| Commercial -  secured and unsecured                                                   |   | 31                          |   | 379 |   |
| Consumer  installment, home equity lines of credit and unsecured loans to individuals |   | 4                           |   | — |   |
|                                                                                  |   |                        |   |   |   |
| Total loans  charged-off                                                              |   | 35                          |   | 402 |   |
|                                                                                  |   |                        |   |   |   |
| 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                                                   |   | 11                          |   | 87 |   |
| Consumer  installment, home equity lines of credit and unsecured loans to individuals |   | 16                          |   | 53 |   |
|                                                                                  |   |                        |   |   |   |
| Total recoveries  of loans previously charged off                                     |   | 33                          |   | 140 |   |
| Net charge-offs                                                                       |   | 2                           |   | 262 |   |
| Provision for  credit losses                                                          |   | —                      |   | 110 |   |
|                                                                                  |   |                        |   |   |   |
| Balance, end of  period                                                               |   | $                           | 3,633  |   | $ | 4,694 |   |

 

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

 

NOTE 5—GOODWILLAND OTHER INTANGIBLE ASSETS

 

As of March 31, 2004 and December 31, 2003, the Company had goodwill of$3.2 million, and net core deposit intangibles of $1.8 million and $1.9million, respectively, from its acquisition of South Bay Bank in December 2001.  The

 

8

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gross carrying amount of core deposit intangibles was $2.3 million atMarch 31, 2004 and December 31, 2003, and accumulated amortization was $502,000and $447,000, respectively, at such dates. The core deposit intangibles are estimated to have a life of 10 yearsand 4 months. Amortization for intangibles for 2004 and each of the next fouryears is estimated to be $223,000 per year. In accordance with SFAS No. 142 goodwill is not amortized.  The Company has no other indefinite-livedintangible assets.

 

NOTE 6—INCOMETAXES

 

Income tax provisions of $202,000 and $107,000 were recorded for thethree months ended March 31, 2004 and 2003, respectively.

 

At March 31, 2004, the Company had: (i) federal net operating losscarry forwards (“NOLS”) of approximately $18.4 million, which begin to expirein the year 2009; (ii) California NOLS of $273,000 which will expire in 2005;(iii) a federal alternative minimum tax “AMT” credit of $298,000; and (iv) aCalifornia AMT of $16,000.  The CaliforniaNOLS were scheduled to expire in 2002; the state legislature suspended NOLSutilization and extended the related carry forwards expiration.  The AMT credits carry forward indefinitely.

 

Management believes that it is more likely than not that the deferredtax asset will be realized. Accordingly, no valuation allowance has been established against thedeferred tax asset.

 

NOTE 7—BENEFITPLANS

 

The estimated per share weighted average fair value of options grantedwas $7.28 and $4.85 for the three months ended March 31, 2004 and 2003,respectively.  The Company appliesAccounting Principles Board Opinion No. 25 and related Interpretations inaccounting for its stock incentive plans. SFAS No. 123, Accounting for Stock-Based Compensation, encourages, butdoes not require, companies to record compensation cost for stock-basedemployee compensation plans at fair value. Accordingly, no compensation cost has been recognized for the options.  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 thethree months ended March 31, 2004 and 2003 would have decreased by $28,000 and$26,000 respectively.  Basic and dilutedearnings per share would have decreased by $0.01 for the three months endedMarch 31, 2004 and 2003.

 

9

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The fair values of options granted during the three months ended March31, 2004 and 2003 were estimated on the date of grant using the Black-Scholesoption-pricing model with the following weighted-average assumptions used:2004— no dividend yield, expected volatility of 62%, risk-free interest rate of3.85%, and an expected life of 10 years; 2003— no dividend yield, expectedvolatility of 60%, risk-free interest rate of 3.82%, and an expected life of 10years.

 

NOTE8—COMPREHENSIVE NET INCOME

 

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

 
|                                                                                 |   | **For the  three months ended  March 31,** |   |
|--------------------------------------------------------------------------------------|--------|--------------------------------------------|--------|
|                                                                                 |   | **2004**                                   |   | **2003** |   |
|                                                                                 |   | **(in  thousands)**                        |   |
|                                                                                 |   |                                       |   |   |   |
| Net income                                                                           |   | $                                          | 291    |   | $ | 97 |   |
|                                                                                 |   |                                       |   |   |   |
| Other  comprehensive income, (loss) before tax, and unrealized losses on securities: |   |                                       |   |   |   |
| Unrealized gain  (loss) on securities available for sale                             |   | 31                                         |   | (188 | ) |
| Other  comprehensive income (loss), before tax                                       |   | 31                                         |   | (188 | ) |
|                                                                                 |   |                                       |   |   |   |
| Income tax  benefit (expense) related to items of other comprehensive income         |   | (13                                        | )      | 78 |   |
| Other  comprehensive income, (loss)                                                  |   | 18                                         |   | (110 | ) |
| Total  comprehensive income, (loss)                                                  |   | $                                          | 309    |   | $ | (13 | ) |

 

NOTE 9—JUNIORSUBORDINATED DEFERRABLE INTEREST DEBENTURES

 

In 2001, the Company, through National Mercantile Capital Trust I (the“Trust”), issued 15,000 of 10.25% fixed-rate preferred securities due July 25,2031 (the “Trust Preferred Securities”), with a liquidation amount of $1,000per Trust Preferred Security and an aggregate liquidation amount of $15.0million.  The Trust Preferred Securities represent undivided beneficialinterests in the assets of the Trust and are unconditionally guaranteed by theCompany with respect to distributions and payments upon liquidation, redemptionand otherwise pursuant to the terms of a guarantee agreement.

 

The primary assets of the Trust are $15.5 million aggregate principalamount of the Company’s 10.25% fixed-rate junior subordinated deferrableinterest debentures due July 25, 2031, (the “Junior Subordinated Debentures”)that pay interest each

 

10

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January 25 and July 25.  Theinterest is deferrable, at the Company’s option, for a period up to tenconsecutive semi-annual payments, but in any event not beyond June 25,2031.  The debentures are redeemable, inwhole or in part, at the Company’s option on or after five years from issuanceat declining premiums to maturity.

 

The Company adopted FASB Interpretation No. 46,Consolidation of Variable Interest Entities (FIN 46) as of July 1, 2003resulting in the deconsolidation of the Trust. Accordingly, the JuniorSubordinated Debentures have been classified in liabilities at March 31, 2004and the related interest was classified as interest expense for the threemonths then ended.  For dates andperiods prior to the adoption of FIN 46, the Trust Preferred Securities, net ofthe cost of issuance, were recorded as a minority interest and the relatedinterest was recorded as a minority interest in the Company’s income.

 

NOTE 10—DERIVATIVEFINANCIAL INSTRUMENTS

 

In January 2003, the Company entered into an interest rate swapagreement pursuant to which it exchanged a fixed rate payment obligation of10.25% on a notional principal amount of $15.0 million for a floating rateinterest based on the six-month London InterBank Offered Rate plus 458 basispoints for a 29-year period ending July 25, 2031.  The interest rate swap agreement results in the Company paying orreceiving the difference between the fixed and floating rates at specifiedintervals calculated based on the notional amounts.  The differential paid or received on the interest rate swap isrecognized as an adjustment to interest expense.  At March 31, 2004, the Company was paying an interest rate of5.75% 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 swap reduces the adverse impact of the 10.25%fixed-rate Junior Subordinated Debentures in a low interest rate environment.  The Company does not utilize derivatives forspeculative purposes.  Under Statementof Financial Accounting Standards No. 133 this swap transaction is designatedas a fair value hedge.  Accordingly, theineffective portion of the change in the fair value of the swap transaction isrecorded each period in current income. The terms of the swap are symmetrical with the terms of the JuniorSubordinated Debentures, including the payment deferral terms, and consideredhighly effective in offsetting changes in fair value of the Junior SubordinatedDebentures.  A $43,000 increase in thefair value of the swap was recorded in income for the three-month period endedMarch 31, 2004 with an offsetting charge to earnings to reflect a similardecrease in the fair value of the Junior Subordinated Debentures.   No ineffectiveness was recorded to currentearnings related to the interest rate swap.

 

The terms of the Swap require the Company to provide collateral tosupport its contract obligations and varies based upon the Swap contractvalue.  At March 31, 2004, $1.6 millionin securities were pledged as collateral.

 

11

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NOTE 11— CONVERSION OF PREFERRED STOCK

 

In the three months ended March 31, 2004, 63,312 shares of Series Anon-cumulative convertible perpetual

preferred stock were converted to 126,624 shares ofcommon stock.

 

NOTE 12—RECLASSIFICATIONS

 

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

 

NOTE 13—ACCOUNTING PRONOUNCEMENTS

 

In May 2003, the FASB issued Statement of Financial AccountingStandards No. 150, Accounting for Certain Financial Instruments withCharacteristics of both Liabilities and Equity (SFAS 150).  SFAS 150 establishes standards for how anissuer classifies and measures certain financial instruments withcharacteristics of both liabilities and equity.  It requires than an issuer classify a financial instrument thatis within its scope as a liability (or an asset in some circumstances).  Many of those instruments were previouslyclassified as equity.  The Companyadopted SFAS 150 effective July 1, 2003, which had no effect on the Company’sfinancial statements.

 

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

 

National Mercantile Bancorp (“National Mercantile” on a parent-onlybasis, and the ‘‘Company’’ on a consolidated basis) is the holding company fortwo subsidiary banks, Mercantile National Bank (“Mercantile”) and South BayBank, N.A. (“South Bay”) (collectively, “the Banks”).  National Mercantile’s principal assets are the capital stock ofMercantile and South Bay.

 

In July 2001, National Mercantile formed National Mercantile CapitalTrust (the “Trust”) as a Delaware statutory business trust formed for the exclusivepurpose of issuing and selling trust preferred securities (the “Trust PreferredSecurities”).  The Trust issued thosesecurities and utilized the proceeds to purchase from National Mercantile, itsjunior subordinated deferrable interest debentures (the “Junior SubordinatedDebentures”).  Through June 30, 2003,the Company’s financial statements reflected the Trust as a consolidatedsubsidiary, with the effect that the Trust Preferred Securities of the Trustwere reflected on the balance sheet as mezzanine equity and payments on theTrust Preferred Securities were set forth as expenses classified as

 

12

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minority interest in the Company’s income of the guaranteed preferredbeneficial interest in the Junior Subordinated Debentures.

 

The Company implemented FIN 46 effective July1, 2003 with the effect that since that date the Trust has not been aconsolidated subsidiary of the Company for financial reporting purposes.  As a result: (i) the Company’s balance sheetsas of dates on or after July 1, 2003 no longer reflect the Trust PreferredSecurities as mezzanine equity but instead reflect the Junior SubordinatedDebentures as liabilities, and (ii) the Company’s statements of operationsincorporating periods on or after July 1, 2003, reflect from July 1, 2003forward interest payments on the Junior Subordinated Debentures as interestexpense and do not reflect payments on the Trust Preferred Securities asexpenses classified as minority interest in the Company’s income of theguaranteed preferred beneficial interest in the Company’s Junior SubordinatedDebentures.  As discussed below, thishas a significant effect on comparisons of net interest income between periodsincluding and not including periods on and after July 1, 2003.

 

**RESULTSOF OPERATIONS**

 

The Company recorded net income of $291,000, or $0.10 basic earningsper share and $0.06 diluted earning per share, for the three months ended March31, 2004 compared to net income of $97,000, or $0.04 basic earnings per shareand $.02 diluted earnings per share, for the same period of 2003.   The increase in net income for the 2004period was primarily due to a $415,000 reduction in interest expense ondeposits and a $110,000 reduction in the provision for credit losses. This waspartially offset by a reduction in total interest income of $269,000 and a$95,000 increase in income tax provisions. Net interest income before provision for credit losses for the threemonths ended March 31, 2004 reflects a $71,000 decline from the same period in2003.   This decline, however, includes$226,000 in interest expense related to the Company’s Junior SubordinatedDebentures in the 2004 period.  Duringthe 2003 period, this interest was reported as minority interest in the Company’sincome of the Junior Subordinated Debentures. As discussed above, this reclassification was due to the implementationof Financial Accounting Standards Board Interpretation 46 (“Fin 46”).

 

Return on average assets during the first quarter 2004 was 0.32%,compared to 0.11% during the first quarter of 2003. Return on average equityduring the first quarter of 2004 was 3.63%, compared to a  1.26% during the first quarter of 2003.

 

13

----

 

NET INTERESTINCOME

 

Net interest income before the provision for credit losses decreased$71,000 for the first quarter of 2004 compared to the first quarter of 2003 dueto the inclusion of interest on the Junior Subordinated Debentures in the 2004quarter.  This accounting change alsoresulted in a 0.25% reduction in the interest margin (net yield on interestearning assets) from 4.60% to 4.35%. 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 decreased as the 0.54% decline in the weighted averageyield on interest earning assets more than offset the $8.9 million increase inaverage interest earning assets.  Thereduction in the weighted average yield on interest earning assets was due to:(i) a decline in market interest rates, resulting in a repricing of adjustablerate assets (primarily loans) and lower yields on newly originated or purchasedassets and (ii) lower yielding assets comprising a greater portion of ourinterest earning assets, due to a decline in average loans and an increase inaverage securities and other assets, as we invested funds from deposits andloan payoffs in securities and other short-term assets pending deployment intoloans.  Loan yields declined less thanother earning assets due to the fixed rate loans in the portfolio.  The increase in average interest earningassets reflects management’s growth strategy.

 

Interest expense decreased as well due to a 0.49% decline in theweighted average rates on interest bearing liabilities, which more than offseta $10.1 million increase in average interest-bearing liabilities. The reductionin the weighted average rate was due to: (i) a decline in market interest ratesand (ii) an increase in lower-cost demand, savings and money market depositsand reduction in higher-costs certificates of deposit.  This was offset in part by the inclusion ofinterest on the higher cost Junior Subordinated Debentures as interest expense,which also resulted in the increase in average interest bearing liabilities, asthe average interest bearing deposits decreased by $5.5 million.

 

Average loans receivable decreased $10.0 million or 3.7% for the threemonths ended March 31, 2004 compared to the same period in 2003 primarily dueto a decline in construction loans in the 2004 period.  Due to the nature of construction loans, theoutstanding balance of newly originated loans increases gradually during thelife of the loan and repays in a lump sum. The weighted average yield on loans receivable declined 33 basis pointsto 5.86% for the first quarter 2004. The lower yields on loans receivable are due to the sustained decline ininterest rates over the past two years affecting the yields on adjustable rateloans tied to rate indices as well as the yields on newly originated fixed rateloans and existing fixed rate loans upon renewal at maturity.

 

14

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Average securities available-for-sale increased to $32.9 million forthe three months ended March 31, 2004 compared to $26.2 million for the periodended March 31, 2003.   The weightedaverage yield on securities available-for-sale was 3.12% and 3.87% for thethree months ended March 31, 2004 and 2003, respectively, representing a 75basis point decline.  The decline inyield was due to purchases of securities in the declining rate environmentduring 2003 and to a lesser extent, adjustable rate securities in theportfolio.  Securities held-to-maturityaveraged $4.5 million for the period ended March 31, 2004. The weighted averageyield on securities held-for-maturity was 3.73% for the three months endedMarch 31, 2004.  There were nosecurities held-for-maturity during the three months ended March 31, 2003.

 

Average total deposits increased $12.1 million or 4.1% to $304.2million during the first quarter of 2004 compared to $292.1 million during thefirst quarter of 2003.  This was due toan increase of $17.5 million in average non-interest bearing deposits, asinterest bearing deposits declined due to the continued fun-off of timecertificates of deposit.  This change inmix of the deposits reflects management’s continued emphasis on businessbanking at South Bay and replacing certificates of deposit with transactionaccounts.

 

The following table presents the components of net interest income forthe three months ended March 31, 2004 and 2003.

 

15

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**AverageBalance Sheet and**

**Analysisof Net Interest Income**

 
|                                                                                                                      |   | **Three  months ended**     |    |
|---------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|---------|
|                                                                                                                      |   | **March 31,  2004**         |    | **March 31,  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                                                   |   | $                           | 17,436  |   | 42 |   | 0.97 | % | $ | 14,511 |   | $ | 43 |   | 1.20 | % |
| Due from  banks-interest bearing                                                                                          |   | 4,697                       |    | 15 |   | 1.28 | % | — |   | — |   | — |   |
| Securities  available-for-sale                                                                                            |   | 32,920                      |    | 257 |   | 3.12 | % | 26,192 |   | 250 |   | 3.87 | % |
| Securities  held-to-maturity                                                                                              |   | 4,509                       |    | 42 |   | 3.73 | % | — |   | — |   | — |   |
| Loans receivable  (1) (2)                                                                                                 |   | 259,664                     |    | 3,785 |   | 5.86 | % | 269,644 |   | 4,117 |   | 6.19 | % |
| Total interest  earning assets                                                                                            |   | 319,226                     |    | 4,141 |   | 5.22 | % | 310,347 |   | 4,410 |   | 5.76 | % |
|                                                                                                                      |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Noninterest  earning assets:                                                                                              |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Cash and due  from banks - demand                                                                                         |   | 22,963                      |    |   |   |   |   | 20,823 |   |   |   |   |   |
| Other assets                                                                                                              |   | 21,491                      |    |   |   |   |   | 20,157 |   |   |   |   |   |
| Allowance for  credit losses and net unrealized gain on sales of securities  available-for-sale                           |   | (3,527                      | )       |   |   |   |   | (4,626 | ) |   |   |   |   |
| Total assets                                                                                                              |   | $                           | 360,153 |   |   |   |   |   | $ | 346,701 |   |   |   |   |   |
|                                                                                                                      |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Liabilities and  shareholders’ equity:                                                                               |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  deposits:                                                                                               |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Demand                                                                                                                    |   | $                           | 29,927  |   | 17 |   | 0.23 | % | $ | 27,651 |   | $ | 61 |   | 0.89 | % |
| Money market and  savings                                                                                                 |   | 100,537                     |    | 163 |   | 0.65 | % | 88,976 |   | 301 |   | 1.37 | % |
| Time  certificates of deposit:                                                                                            |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| $100,000 or more                                                                                                          |   | 24,141                      |    | 83 |   | 1.38 | % | 28,845 |   | 147 |   | 2.07 | % |
| Under $100,000                                                                                                            |   | 26,373                      |    | 113 |   | 1.72 | % | 40,958 |   | 282 |   | 2.79 | % |
| Total time  certificates of deposit                                                                                       |   | 50,514                      |    | 196 |   | 1.56 | % | 69,803 |   | 429 |   | 2.49 | % |
| Total  interest-bearing deposits                                                                                          |   | 180,978                     |    | 376 |   | 0.84 | % | 186,430 |   | 791 |   | 1.72 | % |
| Other borrowings                                                                                                          |   | 7,500                       |    | 88 |   | 4.72 | % | 7,500 |   | 89 |   | 4.81 | % |
| Junior  subordinated debentures                                                                                           |   | 15,464                      |    | 226 |   | 5.88 | % | — |   | — |   | — |   |
| Federal funds  purchased and securities sold under agreements to repurchase                                               |   | 232                         |    | — |   | 0.00 | % | 1,134 |   | 8 |   | 2.86 | % |
| Total  interest-bearing liabilities                                                                                       |   | 204,174                     |    | 690 |   | 1.36 | % | 195,064 |   | 888 |   | 1.85 | % |
|                                                                                                                      |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  liabilities:                                                                                         |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  demand deposits                                                                                      |   | 123,195                     |    |   |   |   |   | 105,683 |   |   |   |   |   |
| Other  liabilities                                                                                                        |   | 612                         |    |   |   |   |   | 225 |   |   |   |   |   |
| Guaranteed  preferred beneficial interests in the Company’s junior subordinated  deferrable interest debentures, net |   | —                      |    |   |   |   |   | 14,532 |   |   |   |   |   |
| Shareholders’  equity                                                                                                |   | 32,172                      |    |   |   |   |   | 31,197 |   |   |   |   |   |
| Total  liabilities and shareholders’ equity                                                                          |   | $                           | 360,153 |   |   |   |   |   | $ | 346,701 |   |   |   |   |   |
|                                                                                                                      |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Net interest  income (spread)                                                                                             |   |                        |    | $ | 3,451 |   | 3.86 | % |   |   | $ | 3,522 |   | 3.91 | % |
|                                                                                                                      |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Net yield on  earning assets (2)                                                                                          |   |                        |    |   |   | 4.35 | % |   |   |   |   | 4.60 | % |
|                                                                                                                           |        |                             |         |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

(2) Yields andamounts earned on loans receivable include loan fees of $293,000 and $190,000for the three months ended March 31, 2004 and 2003, respectively.

 

16

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

 

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

**AverageVolume and Average Rate (1)**

 
|                                                                        |   | **Three  months ended March 31,  2004 vs 2003** |   |
|-----------------------------------------------------------------------------|--------|-------------------------------------------------|--------|
|                                                                        |   |                                            |   |   |   | **Net  Increase  (Decrease)** |   |
|                                                                        |   | **Increase  (decrease) due to:**                |   |   |
|                                                                        |   | **Volume**                                      |   | **Rate** |   |   |
|                                                                        |   | **(Dollars  in thousand)**                      |   |
| Interest Income:                                                            |   |                                            |   |   |   |   |   |
| Federal funds  sold and securities purchased under agreement to resell      |   | $                                               | 9      |   | $ | (10 | ) | $ | (1 | ) |
| Interest-bearing  deposits with other financial institutions                |   | 15                                              |   | — |   | 15 |   |
| Securities  available-for-sale                                              |   | 67                                              |   | (60 | ) | 7 |   |
| Securities  held-to-maturity                                                |   | 42                                              |   | — |   | 42 |   |
| Loans receivable  (2)                                                       |   | (140                                            | )      | (192 | ) | (332 | ) |
| Total  interest-earning assets                                              |   | (7                                              | )      | (262 | ) | (269 | ) |
|                                                                        |   |                                            |   |   |   |   |   |
| Interest  Expense:                                                          |   |                                            |   |   |   |   |   |
| Interest-bearing  deposits:                                                 |   |                                            |   |   |   |   |   |
| Demand                                                                      |   | $                                               | 5      |   | $ | (49 | ) | $ | (44 | ) |
| Money market and  savings                                                   |   | 39                                              |   | (177 | ) | (138 | ) |
| Time  certificates of deposit:                                              |   |                                            |   |   |   |   |   |
| $100,000 or more                                                            |   | (24                                             | )      | (40 | ) | (64 | ) |
| Under $100,000                                                              |   | (99                                             | )      | (70 | ) | (169 | ) |
| Total time  certificates of deposit                                         |   | (123                                            | )      | (110 | ) | (233 | ) |
| Total  interest-bearing deposits                                            |   | (79                                             | )      | (336 | ) | (415 | ) |
| Other borrowings                                                            |   | —                                          |   | (1 | ) | (1 | ) |
| Junior  subordinated debentures                                             |   | 226                                             |   | — |   | 226 |   |
| Federal funds  purchased and securities sold under agreements to repurchase |   | (6                                              | )      | (2 | ) | (8 | ) |
| Total  interest-bearing liabilities                                         |   | 141                                             |   | (339 | ) | (198 | ) |
|                                                                        |   |                                            |   |   |   |   |   |
| Net interest  income                                                        |   | $                                               | (148   | ) | $ | 77 |   | $ | (71 | ) |

 

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(1)     The change in interest incomeor interest expense that is attributable to both changes in average balance,average rate and days in the quarter has been allocated to the changes due to(i) average balance and (ii) average rate in proportion to the relationship ofthe absolute amounts of changes in each.

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

 

17

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PROVISION FORCREDIT LOSSES

 

Provisions for credit losses were $0 and $110,000 for the three monthsended March 31, 2004, and 2003, respectively. The decrease in provisions forcredit losses during the first quarter 2004 was due to the current adequacy ofthe allowance for credit losses based upon our analysis.  See Note 4 of Notes to ConsolidatedFinancial Statements.

 

OTHER OPERATINGINCOME

 

Other operating income increased to $465,000 during the first quarterof 2004 from $435,000 during the first quarter of 2003 primarily due to anincrease in deposit-related and other customer service income due to increasedfees and new product introduction, partially offset by a decrease in net gainon sale of securities available-for-sale.

 

Net gains on sales of securities are generated primarily in declininginterest rate environments.  Accordingly, gains or losses from sales of securities may fluctuatesignificantly from period to period, and the results in any period are notnecessarily indicative of the results, which may be obtained in future periods.

 

OTHER OPERATING EXPENSES

 

Other operating expenseswere nearly unchanged at $3.4 million for the three months ended March 31, 2004and for the same period in 2003. Variances within operating expenses werereflected as follows; (i) salaries and related benefits expense increased$41,000 or 2.2%; (ii) net occupancy expense decreased $38,000 or 11.6%; (iii)furniture and equipment expense increased $27,000 or 24.8%; (iv) customerserivces expense decreased $46,000, or 25.8%; (v) computer data processingexpense increased $46,000 or 21.4%; (vi) legal services expense decreased $40,000 or 28.0%;  (vii) other professional services expensedecreased $43,000 or 19.1%; and (viii) retirement of fixed assets and leaseholdimprovements expenses increased $43,000.

 

The increase in salaryand related expense in the first quarter of 2004  is due to greater commission payments on increased loanproduction.  The officer and staffsalary expense increased but was offset by the decrease in temporary helpexpense.  The decrease in occupancyexpense was due to a decrease in rent expense from the move of the corporateheadquarters in January 2004. The increase in furniture and equipment expenseis due to an increase in maintenance and repairs of computers primarily due tothe temporary moves of the corporate headquarters and the Beverly Hills loanproduction office.  The decrease inclient services is primarily related to the decrease in services for the escrowcustomers.  Data processing expenseincreased due to increased volume of accounts and activity. Legal expensesdecreased for the collection of loans due to fewer past due loans and fewerother real estate owned properties. Professional services expense decreased due to a reduction

 

18

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in professional services for nonperforming assets at South Bay.  The increase of promotional and otherexpenses is due to the move of the corporate headquarters prior to the end ofthe lease.

 

MINORITY INTERESTIN THE COMPANY’S INCOME

 

The minority interest in the Company’s income of the guaranteedbeneficial interest in the Company’s Junior Subordinated Debentures was$233,000 for the three months ended March 31, 2003.  As a result of the reclassification pursuant to FIN 46 effectiveJuly 1, 2003, no such minority interest expense was recorded for the threemonths ended March 31, 2004.

 

***BALANCE SHEET ANALYSIS***

 

INVESTMENT SECURITIES

 

The followingcomparative period-end table sets forth certain information concerning theestimated fair values and

unrealized gains and losses of securities available-for-sale andsecurities held-to-maturity.

 

19

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**EstimatedFair Values of and Unrealized**

**Gainsand Losses on Securities**

 
|                                                                      |   | **March 31, 2004**         |   |
|---------------------------------------------------------------------------|--------|----------------------------|--------|
|                                                                      |   | **Total  amortized  cost** |   | **Gross  unrealized  gains** |   | **Gross  unrealized  loss** |   | **Estimated  fair  value** |   |
|                                                                      |   | **(Dollars in thousands)** |   |
| **Available-for-Sale:**                                                   |   |                       |   |   |   |   |   |   |   |
| U.S. Treasury  securities                                                 |   | $                          | 704    |   | $ | — |   | $ | — |   | $ | 704 |   |
| GNMA-issued/guaranteed  mortgage pass through certificates                |   | 281                        |   | 11 |   | — |   | 292 |   |
| Other U.S.  Government and federal agency securities                      |   | 19,063                     |   | 91 |   | — |   | 19,154 |   |
| FHLMC/FNMA-issued  mortgage pass through certificates                     |   | 4,848                      |   | 155 |   | — |   | 5,003 |   |
| CMO’s and  REMIC’s issued by U.S. government-sponsored agencies |   | 50                         |   | 2 |   | — |   | 52 |   |
| Mutual funds                                                              |   | 10,000                     |   | — |   | 109 |   | 9,891 |   |
| Privately issued  corporate bonds, CMO and REMIC securities               |   | 1,084                      |   | 2 |   | — |   | 1,086 |   |
|                                                                      |   | $                          | 36,030 |   | $ | 261 |   | $ | 109 |   | $ | 36,182 |   |
|                                                                      |   |                       |   |   |   |   |   |   |   |
| FRB and other  equity stocks                                              |   | $                          | 1,872  |   | — |   | — |   | $ | 1,872 |   |
|                                                                      |   |                       |   |   |   |   |   |   |   |
| **Held-to-Maturity:**                                                     |   |                       |   |   |   |   |   |   |   |
| FHLMC/FNMA-issued  mortgage pass through certificates                     |   | $                          | 4,374  |   | $ | 49 |   | $ | — |   | $ | 4,423 |   |
|                                                                      |   |                       |   |   |   |   |   |   |   |
|                                                                      |   | $                          | 4,374  |   | $ | 49 |   | $ | — |   | $ | 4,423 |   |

 
|                                                                      |   | **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 |   |
|                                                                      |   |                       |   |   |   |   |   |   |   |
| **Held-to-Maturity:**                                                     |   |                       |   |   |   |   |   |   |   |
| FHLMC/FNMA-issued  mortgage pass through certificates                     |   | $                          | 4,597  |   | $ | 43 |   | $ | — |   | $ | 4,640 |   |
|                                                                      |   |                       |   |   |   |   |   |   |   |
|                                                                      |   | $                          | 4,597  |   | $ | 43 |   | $ | — |   | $ | 4,640 |   |

 

20

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Asof March 31, 2004 the Company did not hold securities of any issuer, other thanU.S. government agencies and corporations, the aggregate book value of whichexceeded 10% of the Company’s shareholders’ equity.   At March 31, 2004, the Company held $9.9 million of anadjustable rate mortgage mutual fund in which the funds holdings are primarilycomprised of U.S. Agency securities, agency mortgage pools and U.S. Treasurysecurities.  The Company had $4.4million and $4.6 million securities classified as held-to-maturity at March 31,2004 and December 31, 2003, respectively.

 

LOAN PORTFOLIO

 

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

 

**Loan Portfolio Composition**

 
|                                                                  |   | **March 31,  2004**         |    | **December  31,  2003** |   |
|-----------------------------------------------------------------------|--------|-----------------------------|---------|-------------------------|--------|
|                                                                  |   | **Amount**                  |    | **Percent**             |   | **Amount** |   | **Percent** |   |
|                                                                  |   | **(Dollars  in thousands)** |    |
| Real estate loans:                                                    |   |                        |    |                    |   |   |   |   |   |
| Secured by one to four family residential  properties                 |   | $                           | 7,811   |                    | 3      | % | $ | 8,167 |   | 3 | % |
| Secured by multifamily residential  properties                        |   | 13,070                      |    | 5                       | %      | 13,071 |   | 5 | % |
| Secured by commercial real properties                                 |   | 137,601                     |    | 52                      | %      | 132,320 |   | 52 | % |
| Real estate construction and land  development                        |   | 26,632                      |    | 10                      | %      | 27,210 |   | 10 | % |
| Commercial loans - secured and unsecured                              |   | 78,020                      |    | 29                      | %      | 76,699 |   | 29 | % |
| Consumer installment, home equity and  unsecured loans to individuals |   | 2,726                       |    | 1                       | %      | 3,510 |   | 1 | % |
| Total loans outstanding                                               |   | 265,860                     |    | 100                     | %      | 260,977 |   | 100 | % |
|                                                                  |   |                        |    |                    |   |   |   |   |   |
| Deferred net loan origination fees and  purchased loan discount       |   | (781                        | )       |                    |   | (728 | ) |   |   |
| Loans receivable, net                                                 |   | $                           | 265,079 |                    |   |   | $ | 260,249 |   |   |   |

 

Total loans outstanding increased by $4.8 million to $265.1 million atMarch 31, 2004 compared to $260.2 million at December 31, 2003 as loanoriginations exceeded loan payoffs.  Theloan originations were primarily in real estate loans secured by commercialreal property.

 

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NONPERFORMING ASSETS

 

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

 

**NonperformingAssets**

 
|                                                                                                                       |   | **March 31,  2004**         |   | **December  31  2003** |   |
|----------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|--------|------------------------|--------|
|                                                                                                                       |   | **(Dollars  in thousands)** |   |
|                                                                                                                       |   |                        |   |                   |   |
| Nonaccrual loans                                                                                                           |   | $                           | 319    |                   | $      | 438 |   |
| Troubled debt restructurings                                                                                               |   | —                      |   | —                 |   |
| Loans contractually past due ninety or more  days with respect to either principal or interest and still accruing interest |   | —                      |   | —                 |   |
| Nonperforming loans                                                                                                        |   | 319                         |   | 438                    |   |
| Other real estate owned                                                                                                    |   | 968                         |   | 925                    |   |
| Other nonperforming assets                                                                                                 |   | —                      |   | —                 |   |
| Total nonperforming assets                                                                                                 |   | $                           | 1,287  |                   | $      | 1,363 |   |
|                                                                                                                       |   |                        |   |                   |   |
| Allowance for credit losses as a percent of  nonaccrual loans                                                              |   | 1139.5                      | %      | 829.9                  | %      |
| Allowance for credit losses as a percent of  nonperforming loans                                                           |   | 1139.5                      | %      | 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 $119,000 at March 31, 2004 to $319,000 from$438,000 at December 31, 2003 due primarily to collection of nonaccrual loansand loan charge offs. There were no loans past due 90 days or more and stillaccruing interest at March 31, 2004 and December 31, 2003.  Other real estate owned  increased $43,000 at March 31, 2004 to$968,000 form $925,000  at December 31,2003 due to capitalization of expenditures for improvements.  The amount of nonperforming assets at March31, 2004 decreased to $1.3 million from $1.4 million at December 31, 2003.

 

ALLOWANCE FOR CREDIT LOSSES

 

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

 

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Loans charged off during the first quarter of 2004 were $35,000,compared to $402,000 during the first quarter of 2003.  Recoveries of loans previously charged offwere $33,000  during the first quarterof 2004 compared to $140,000 during the first quarter of 2003.  See Note 4 of Notes to ConsolidatedFinancial Statements.

 

Credit quality is affected by many factors beyond the control of theCompany, including local and national economies, and facts may exist which arenot known to the Company that adversely affect the likelihood of repayment ofvarious loans in the loan portfolio and realization of collateral upon a default.Accordingly, no assurance can be given that the Company will not sustain loanlosses materially in excess of the allowance for credit losses. In addition,the Office of the Comptroller of the Currency (“OCC”), as an integral part ofits examination process, periodically reviews the allowance for credit lossesand could require additional provisions for credit losses.

 

DEPOSITS

 

Total deposits were $317.2 million and $298.7 million at March 31, 2004and December 31, 2003, respectively. Noninterest-bearing demand deposits and money market deposits were$127.4 million and $70.5 million, respectively, at March 31, 2004 compared to$120.0 million and $55.4 million, respectively, at December 31, 2003.Interest-bearing demand deposits, which are largely limited to individuals,increased to $31.6 million at March 31, 2004 from $29.3 million at December 31,2003.  The increase in these accounts isattributable to an emphasis on growing business banking through the hiring ofcommercial lending officers, which generates transaction deposit accounts.  Savings deposits increased to $40.1 millionat March 31, 2004 compared to $38.9 million at December 31, 2003 reflecting therelative higher yields being paid on this deposit type.  Time certificates of deposit (“TCDs”)decreased to $47.6 million at March 31, 2004 from $55.0 million at December 31,2003.  This decrease is due to anemphasis on growing lower cost transaction accounts.  There were no brokered TCDs at March 31, 2004 and $5.0 millionbrokered TCDs at December 31, 2003.

 

FEDERAL FUNDS SOLD AND SECURITIES SOLD UNDERAGREEMENTS TO REPURCHASE

 

There were no federal funds sold and securities sold under agreementsto repurchase at March 31, 2004 compared to $399,000 at December 31, 2003.   The decline is due to the planned runoff ofthe higher costing liabilities at South Bay.

 

23

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OTHER BORROWINGS

 

Other borrowingswere $7.5 million at March 31, 2004 and December 31, 2003 representing advancesfrom the Federal Home Loan Bank.

 

JUNIOR SUBORDINATED DEFERRABLE INTERESTDEBENTURES

 

JuniorSubordinated Debentures were $15.5 million at March 31, 2004, reflecting thereclassification of trust preferred securities formerly reflected as minorityinterest.  See Note 9 of Notes toConsolidated Financial Statements.

 

SHAREHOLDERS’ EQUITY

 

Shareholders’ equity increased from $31.7 million at December 31, 2003to $32.0 million at March 31, 2004 due to the income for the three months endedMarch 31, 2004 and the increases in market value of securitiesavailable-for-sale.

 

***CAPITAL ADEQUACY REQUIREMENTS***

 

At March 31, 2004 the Company and the Banks were in compliance with allapplicable regulatory capital requirements and the Banks were “wellcapitalized” under the Prompt Corrective Action rules of the OCC.  The following table sets forth theregulatory capital standards for well-capitalized institutions, and the capitalratios for the Company and the Banks as of March 31, 2004 and December 31, 2003.

 

24

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**Regulatory Capital Information**

**of the National MercantileBancorp and Banks**

 
|                             |   | **Minimum  For Capital  Adequacy  Purposes** |   | **Well  Capitalized  Standards** |   | **March 31,  2004** |   | **December  31,  2003** |   |
|----------------------------------|--------|----------------------------------------------|--------|----------------------------------|--------|---------------------|--------|-------------------------|--------|
| **National Mercantile Bancorp:** |   |                                         |   |                             |   |                |   |                    |   |
| Tier 1 leverage                  |   | 4.00                                         | %      | N/A                              |   | 9.00                | %      | 8.69                    | %      |
| Tier 1 risk-based capital        |   | 4.00                                         | %      | N/A                              |   | 10.60               | %      | 11.02                   | %      |
| Total risk-based capital         |   | 8.00                                         | %      | N/A                              |   | 13.28               | %      | 13.84                   | %      |
|                             |   |                                         |   |                             |   |                |   |                    |   |
| **Mercantile National Bank:**    |   |                                         |   |                             |   |                |   |                    |   |
| Tier 1 leverage                  |   | 4.00                                         | %      | 5.00                             | %      | 8.46                | %      | 8.13                    | %      |
| Tier 1 risk-based capital        |   | 4.00                                         | %      | 6.00                             | %      | 10.69               | %      | 10.88                   | %      |
| Total risk-based capital         |   | 8.00                                         | %      | 10.00                            | %      | 11.94               | %      | 12.13                   | %      |
|                             |   |                                         |   |                             |   |                |   |                    |   |
| **South Bay Bank, NA:**          |   |                                         |   |                             |   |                |   |                    |   |
| Tier 1 leverage                  |   | 4.00                                         | %      | 5.00                             | %      | 9.92                | %      | 9.44                    | %      |
| Tier 1 risk-based capital        |   | 4.00                                         | %      | 6.00                             | %      | 10.64               | %      | 11.18                   | %      |
| Total risk-based capital         |   | 8.00                                         | %      | 10.00                            | %      | 11.76               | %      | 12.37                   | %      |

 

***LIQUIDITY***

 

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

 

The Company’s cash and due from banks was $25.4 million on March 31,2004 compared to $24.6 million on December 31, 2003.  Due from banks-interest-bearing was $4.3 million and $4.7 millionat March 31, 2004 and December 31, 2003, respectively.  Federal funds sold were $18.0 million and$10.0 million for March 31, 2004 and December 31, 2003, respectively.  Mercantile had $5.0 million and South Bayhad $12.0 million in Federal funds lines with correspondent banks as of March31, 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 the Company’s option, for a period upto ten consecutive semi-annual payments, but in any event not beyond June 25,2031.

 

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National Mercantile’s cash and due from banks was $677,000 on March 31,2004 compared to $1.2 million at December 31, 2003.

 

Dividends and capital distributions from the Banks constitute theprincipal ongoing source of cash to National Mercantile.  National Mercantile is a legal entityseparate and distinct from the Banks, and as such has separate and distinctfinancial obligations including debt service and operating expenses.  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 a dividend if thetotal of all dividends declared in any calendar year exceeds the total of thebank’s net profits (as defined) for that year combined with its retained netprofits for the preceding two calendar years, less any required transfer tosurplus 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 with regulatory capitalrequirements 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.     Excepts under certaincircumstances, and with prior regulatory approval, a bank may not pay adividend if, after so doing, it would be undercapitalized.  The Bank’s ability to pay dividends in thefuture is, and could be, further influenced by regulatory policies oragreements and by capital guidelines.

 

Mercantile has a substantial accumulated deficit and does notanticipate having positive retained earnings for the foreseeable future.  South Bay has an accumulated surplus of$130,000 as of December 31, 2003. 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.

 

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

 

26

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***ASSET LIABILITY MANAGEMENT***

 

The following table shows that the Company’s cumulative one-yearinterest rate sensitivity gap indicated an asset sensitive position of $82.3million at March 31, 2004, a $3.6 million decrease from an asset sensitiveposition of $85.9 million at December 31, 2003.  This change resulted primarily from an increase in demand, moneymarket and savings deposits repricing in less than three months, partiallyoffset by an increase in adjustable loans receivable and federal funds sold.

 

The Company’s asset sensitive position during a period of slowlydeclining interest rates is not expected to have a significant negative impacton net interest income since rates paid on the Company’s large base of interestbearing demand, savings and money market deposits historically have not changedproportionately with changes in interest rates.  However, since the Company is in an asset sensitive position, ina period of rapidly declining rates, such as the environment that wasexperienced during 2001 and 2002, the rapid decline will have a negative effecton the Company’s net interest income as changes in the rates of interestbearing deposits historically have not changed in similar magnitude to changesin market interest rates.  Additionally,in relatively low and declining interest rate environments, the interest ratespaid on funding liabilities may begin to reach floors preventing furtherdownward adjustments while rates on earning assets continue to adjust downward.

 

27

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**Rate-SensitiveAssets and Liabilities**

 
|                                                                     |   | **March 31, 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   |   | $                             | 18,000 |   | $ | — |   | $ | — |   | $ | — |   | $ | 18,000 |   |
| Securities at amortized cost                                             |   | 10,977                        |   | 704 |   | 14,311 |   | 14,563 |   | 40,555 |   |
| Due from banks - interest bearing                                        |   | —                        |   | 4,325 |   | — |   | — |   | 4,325 |   |
| FRB and other stock, at cost                                             |   | —                        |   | — |   | — |   | 1,872 |   | 1,872 |   |
| Loans receivable (1)                                                     |   | 224,678                       |   | 9,488 |   | 26,695 |   | 3,899 |   | 264,760 |   |
| Total rate-sensitive assets                                              |   | 253,655                       |   | 14,517 |   | 41,006 |   | 20,334 |   | 329,512 |   |
|                                                                     |   |                          |   |   |   |   |   |   |   |   |   |
| Rate-Sensitive Liabilities:   (2)                                   |   |                          |   |   |   |   |   |   |   |   |   |
| Interest bearing deposits:                                               |   |                          |   |   |   |   |   |   |   |   |   |
| Demand, money market and savings                                         |   | 142,183                       |   | — |   | — |   | — |   | 142,183 |   |
| Time certificates of deposit                                             |   | 16,759                        |   | 21,376 |   | 8,126 |   | 383 |   | 46,644 |   |
| Other borrowings                                                         |   | —                        |   | 5,500 |   | 2,000 |   | — |   | 7,500 |   |
| Total rate-sensitive liabilities                                         |   | 158,942                       |   | 26,876 |   | 10,126 |   | 383 |   | 196,327 |   |
| Interest rate-sensitivity gap                                            |   | 94,713                        |   | (12,359 | ) | 30,880 |   | 19,951 |   | 133,185 |   |
| Cumulative interest rate-sensitivity gap                                 |   | $                             | 94,713 |   | $ | 82,354 |   | $ | 113,234 |   | $ | 133,185 |   |   |   |
| Cumulative ratio of rate sensitive assets to rate-sensitive  liabilities |   | 160                           | %      | 144 | % | 158 | % | 168 | % |   |   |
|                                                                          |        |                               |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1) Loans receivable excludes nonaccrual loans.

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

  The distribution of other timedeposits is based on scheduled maturities.

 

28

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**Rate-SensitiveAssets and Liabilities**

 
|                                                                     |   | **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 nonaccrual loans.

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

  The distribution of other timedeposits is based on scheduled maturities.

 

29

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# **FACTORS WHICH MAYAFFECT FUTURE OPERATING RESULTS**

 

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

 

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

 

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

 

•      Our ability to originate loans;

 

•      The ability of our borrowers to make payments ontheir loans;

 

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

 

•      The average life of our interest-earning assets;

 

•      Our ability to generate deposits instead of otheravailable funding alternatives; and

 

•      Our ability to access the wholesale fundingmarket.

 

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

 

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

 

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

 

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

 

We establish allowances for credit losses against each segment of ourloan portfolio.  At March 31, 2004, ourallowance for credit losses equaled 1.4% of loans receivable and 282.3% ofnonperforming loans.  Although webelieved that we had established adequate allowances for credit losses as ofMarch 31, 2004, the credit quality of our assets is affected by many factorsbeyond our control, including local and national economic conditions, and thepossible existence of facts which are not

 

30

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known to us which adverselyaffect the likelihood of repayment of various loans in our loan portfolio andrealization of the collateral upon a default. Accordingly, we can give no assurance that we will not sustain loanlosses materially in excess of the allowance for credit losses.  In addition, the Office of the Comptrollerof the Currency, as an integral part of its examination process, periodicallyreviews our allowance for credit losses and could require additional provisionsfor credit losses.  Material futureadditions to the allowance for credit losses may also be necessary due toincreases in the size and changes in the composition of our loanportfolio.  Increases in our provisionsfor credit losses would adversely affect our results of operations.

 

**Economic conditions may worsen.**

 

Our business is strongly influenced by economic conditions in ourmarket area (principally, the Greater Los Angeles metropolitan area) as well asregional and national economic conditions and in our niche markets, includingthe entertainment industry in Southern California.  During the past several years economic conditions in these areashave been generally unfavorable.  Shouldthe economic condition in these areas continue to be unfavorable, the financialcondition of our borrowers could weaken, which could lead to higher levels ofloan defaults or a decline in the value of collateral for our loans.  In addition, an unfavorable economy couldreduce the demand for our loans and other products and services.

 

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

 

At March 31, 2004, a large majority of our loans outstanding werecollateralized by real properties located in California.  Because of this concentration in California,our financial position and results of operations have been and are expected tocontinue to be influenced by general trends in the California economy and itsreal estate market.  Real estate marketdeclines may adversely affect the values of the properties collateralizingloans.  If the principal balances of ourloans, together with any primary financing on the mortgaged properties, equalor exceed the value of the mortgaged properties, we could incur higher losseson sales of properties collateralizing foreclosed loans.  In addition, California historically hasbeen vulnerable to certain natural disaster risks, such as earthquakes anderosion-caused mudslides, which are not typically covered by the standardhazard insurance policies maintained by borrowers.  Uninsured disasters may adversely impact our ability to recoverlosses on properties affected by such disasters and adversely impact ourresults of operations.

 

**Our business is very competitive.**

 

There is intense competition in Southern California and elsewhere inthe United States for banking customers. We experience competition for deposits from many sources, includingcredit unions, insurance companies and money market and other mutual funds, aswell as other commercial banks and savings institutions.  We compete for loans and deposits primarily

 

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with other commercial banks,mortgage companies, commercial finance companies and savings institutions.  In recent years out-of-state financialinstitutions have entered the California market, which has also increasedcompetition.  Many of our competitorshave greater financial strength, marketing capability and name recognition thanwe do, and operate on a statewide or nationwide basis.  In addition, recent developments intechnology and mass marketing have permitted larger companies to market loansmore aggressively to our small business customers.  Such advantages may give our competitors opportunities to realizegreater efficiencies and economies of scale than we can.  We can provide no assurance that we will beable to compete effectively against our competition.

 

**Our business is heavily regulated.**

 

Both National Mercantile as a bank holding company, and Mercantile andSouth Bay, as national banks, are subject to significant governmental supervisionand regulation, which is intended primarily for the protection ofdepositors.  Statutes and regulationsaffecting us may be changed at any time, and the interpretation of thesestatutes 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.

 

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

 

Statement of Financial Accounting Standards No. 142 “Goodwill and OtherIntangible Assets” (“SFAS No. 142”), among other provisions, prescribes thatgoodwill and intangible assets that have indefinite useful lives will not beamortized but rather tested annually, or more frequently upon the occurrence ofcertain events, for impairment.  SFASNo. 142 provides specific guidance for the testing of goodwill for impairment,which may require re-measurement of the fair value of the reporting unit.  Impairment losses are to be reported as a chargeto current period earnings.

 

We recorded goodwill of $3.2 million in connection with the South Bayacquisition in December 2001.  Duringthe fourth quarter of 2003, we completed the required impairment tests ofgoodwill.  The tests determined that ourgoodwill was not considered impaired. No assurance can be given that our goodwill will not become impaired inthe future.

 

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

 

On a periodic basis, at least annually, we perform an analysis todetermine if it is more likely than not that some or all of the gross deferredtax asset will not be realized.  Factorsused in the analysis that are reflective of the future realization of adeferred tax asset are:

 

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•      Future earnings are assured;

 

•      Expected adequate future taxable income arisingfrom the reversal of temporary differences to realize the tax asset;

 

A valuation allowance may beestablished to reduce the deferred tax asset to its realizable value.  The determination of whether a valuationallowance is necessary involves considering the positive and negative factorsrelated to whether the deferred tax asset is more likely than not to berealized.  Any adjustment required tothe valuation allowance is coupled with a related entry to income taxexpense.  A charge to earnings will bemade in the event that we determine that a valuation allowance to the deferredtax asset is necessary.

 

***ITEM 3. CONTROLS ANDPROCEDURES***

*** ***

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

 

There was nochange in the Company’s internal control over financial reporting during theCompany’s most recently completed fiscal quarter that has materially affected,or is reasonabley likely to materially affect, the Company’s internal controlover financial reporting.

 

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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  April22, 2004, the Company held its annual meeting of shareholders.

 

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

 

(c)    The voting for election of directors is listedbelow.

 

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.

 

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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) *Reportson Form 8-K.*

 

Form 8-K, reporting the Company’s press release regarding first quarter2004 operating results was filed April 22, 2004.

 

**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
|   |          |   | **NATIONAL MERCANTILE BANCORP**                       |   |
|--------|---------------|--------|-------------------------------------------------------|--------|
|   |          |   | (Registrant)                                          |
|   |          |   |                                                  |
| DATE:  | May 14 , 2004 |   | /s/  SCOTT A. MONTGOMERY                    |   |
|   |          |   | **Scott A. Montgomery**                               |
|   |          |   | Chief Executive Officer                               |
|   |          |   |                                                  |
| DATE:  | May 14, 2004  |   | /s/  DAVID R. BROWN                         |   |
|   |          |   | **David R. Brown**                                    |
|   |          |   | Principal Financial and Principal Accounting  Officer |
|        |               |        |                                                       |        |  |

 

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