**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**Form10-QSB**

**x****Quarterly report under section13 or 15(d) of the Securities Exchange Act of 1934**

**for the quarterly period ended  September 30, 2006**

**o**** Transition report under section 13 or 15(d) of the Securities ExchangeAct of 1934 for the transition period from      to     .**

**CommissionFile Number 0-15982**

**NATIONAL MERCANTILE BANCORP**

**(Exactname of small business issuer in its charter)**

| **California**                            |   | **95-3819685**                        |
|-------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of          |   | (I.R.S. Employer  Identification No.) |
| incorporation or  organization)           |   |                                  |
| ** **                                |   | ** **                            |
| **1880  Century Park East**               |   | **90067**                             |
| **Los  Angeles, California**              |   | (Zip Code)                            |
| (Address to  principal executive offices) |   |                                  |

 

**Issuer’stelephone 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 file suchreports), and (2) has been subject to such filing requirements for the past 90days.  o Yes     x  No

Indicated by checkmark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act). 

o Yes   x  No

The number of shares ofCommon Stock, no par value, of the issuer outstanding as of  November 10, 2006 was 5,564,955.

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

 

 

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PART I — FINANCIAL INFORMATION

*Item 1.  Financial Statements*

Presentedare the unaudited consolidated financial statements of National MercantileBancorp and its wholly-owned subsidiaries, Mercantile National Bank and SouthBay Bank, N.A.

2

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**NATIONALMERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

(Unaudited)
|                                                                                                                                                                     | ** ** | **September 30,**          | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|------------------|------------|
|                                                                                                                                                                     | ** ** | **2006**                   | ** ** | **2005**         | ** ** |
|                                                                                                                                                                     | ** ** | **(Dollars in thousands)** | ** ** |
|                                                                                                                                                                     |       |                       |       |             |       |
| ASSETS                                                                                                                                                                   |       |                       |       |             |       |
| Cash and due from  banks-demand                                                                                                                                          |       | $                          | 10,709     |             | $          | 13,507 |   |
| Due from banks-interest  bearing                                                                                                                                         |       | 2,000                      |       | 2,000            |       |
| Federal funds sold                                                                                                                                                       |       | —                     |       | 685              |       |
| Cash and cash  equivalents                                                                                                                                               |       | 12,709                     |       | 16,192           |       |
| Securities  available-for-sale, at fair value;  aggregate amortized cost of $103,945 and $72,428 at September 30, 2006 and  December 31, 2005, respectively              |       | 103,318                    |       | 71,758           |       |
| Securities  held-to-maturity, at amortized cost, aggregate fair value of $2,078 and  $2,572 at September 30, 2006 and December 31, 2005, respectively.                   |       | 2,160                      |       | 2,612            |       |
| FRB and other stock, at  cost                                                                                                                                            |       | 3,790                      |       | 3,809            |       |
| Investment in Capital  Trust                                                                                                                                             |       |                       |       |             |       |
| Loans receivable                                                                                                                                                         |       | 358,220                    |       | 338,558          |       |
| Allowance for  loan and lease losses                                                                                                                                     |       | (4,661                     | )          | (4,468           | )          |
| Net loans  receivable                                                                                                                                                    |       | 353,559                    |       | 334,090          |       |
|                                                                                                                                                                     |       |                       |       |             |       |
| Premises and equipment,  net                                                                                                                                             |       | 5,823                      |       | 5,861            |       |
| Other real estate owned                                                                                                                                                  |       | —                     |       | 1,056            |       |
| Deferred tax asset                                                                                                                                                       |       | 1,864                      |       | 4,442            |       |
| Goodwill                                                                                                                                                                 |       | 3,225                      |       | 3,225            |       |
| Core deposit  intangible, net                                                                                                                                            |       | 1,239                      |       | 1,407            |       |
| Accrued interest  receivable and other assets                                                                                                                            |       | 6,510                      |       | 4,008            |       |
| Total assets                                                                                                                                                             |       | $                          | 494,197    |             | $          | 448,460 |   |
|                                                                                                                                                                     |       |                       |       |             |       |
| LIABILITIES AND  SHAREHOLDERS’ EQUITY                                                                                                                               |       |                       |       |             |       |
| Deposits:                                                                                                                                                                |       |                       |       |             |       |
| Noninterest-bearing  demand                                                                                                                                              |       | $                          | 115,740    |             | $          | 115,924 |   |
| Interest-bearing  demand                                                                                                                                                 |       | 27,768                     |       | 36,018           |       |
| Money market  accounts                                                                                                                                                   |       | 109,210                    |       | 76,334           |       |
| Savings                                                                                                                                                                  |       | 24,435                     |       | 28,208           |       |
| Time  certificates of deposit:                                                                                                                                           |       |                       |       |             |       |
| $100,000 or more                                                                                                                                                         |       | 84,094                     |       | 87,468           |       |
| Under $100,000                                                                                                                                                           |       | 18,171                     |       | 19,256           |       |
| Total deposits                                                                                                                                                           |       | 379,418                    |       | 363,208          |       |
|                                                                                                                                                                     |       |                       |       |             |       |
| Federal funds purchased  and securities sold under agreements to repurchase                                                                                              |       | 45,000                     |       | —           |       |
| Other borrowings                                                                                                                                                         |       | 7,600                      |       | 28,337           |       |
| Junior subordinated  deferrable interest debentures                                                                                                                      |       | 15,464                     |       | 15,464           |       |
| Accrued interest  payable and other liabilities                                                                                                                          |       | 3,939                      |       | 3,288            |       |
| Total  liabilities                                                                                                                                                       |       | 451,421                    |       | 410,297          |       |
|                                                                                                                                                                     |       |                       |       |             |       |
| Shareholders’ equity:                                                                                                                                               |       |                       |       |             |       |
| Preferred Stock,  no par value, authorized 1,000,000 shares:                                                                                                             |       |                       |       |             |       |
| Series B  non-cumulative convertible perpetual preferred stock;  1,000 shares outstanding at September 30, 2006 and December 31, 2005                                    |       | 1,000                      |       | 1,000            |       |
| Common stock, no  par value; authorized 10,000,000 shares;  5,551,267 shares and 5,503,780 shares outstanding at September 30, 2006 and  December 31, 2005, respectively |       | 46,340                     |       | 45,697           |       |
| Accumulated  deficit                                                                                                                                                     |       | (3,422                     | )          | (7,380           | )          |
| Accumulated  other comprehensive loss                                                                                                                                    |       | (1,142                     | )          | (1,154           | )          |
| Total  shareholders’ equity                                                                                                                                         |       | 42,776                     |       | 38,163           |       |
| Total liabilities and  shareholders’ equity                                                                                                                         |       | $                          | 494,197    |             | $          | 448,460 |   |

 

See accompanying notes to consolidated financialstatements.

3

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**NATIONAL MERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

(Unaudited)
| ** **                                                                  | ** ** | **Three Months Ended**                                                | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                  | ** ** | **September 30,**                                                          | ** ** | **September 30,**          | ** ** |
| ** **                                                                  | ** ** | **2006**                                                                        | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                  | ** ** | **(Dollars in thousands, except per share data)** | ** ** |
| Interest income:                                                            |       |                                                                            |       |                            |       |   |   |   |   |
| Loans, including fees                                                       |       | $                                                                               | 7,735      |                            | $          | 6,194 |   | $ | 22,326 |   | $ | 17,312 |   |
| Securities                                                                  |       | 1,408                                                                           |       | 523                             |       | 3,712 |   | 1,268 |   |
| Due from banks - interest bearing                                           |       | 47                                                                              |       | 23                              |       | 98 |   | 57 |   |
| Federal funds sold                                                          |       | 58                                                                              |       | 14                              |       | 76 |   | 43 |   |
| Total interest income                                                       |       | 9,248                                                                           |       | 6,754                           |       | 26,212 |   | 18,680 |   |
| Interest  expense:                                                          |       |                                                                            |       |                            |       |   |   |   |   |
| Deposits:                                                                   |       |                                                                            |       |                            |       |   |   |   |   |
| Interest-bearing demand                                                     |       | 63                                                                              |       | 46                              |       | 165 |   | 113 |   |
| Money market and savings                                                    |       | 929                                                                             |       | 350                             |       | 2,310 |   | 804 |   |
| Time certificates of deposit:                                               |       |                                                                            |       |                            |       |   |   |   |   |
| $100,000 or more                                                            |       | 924                                                                             |       | 323                             |       | 2,683 |   | 790 |   |
| Under $100,000                                                              |       | 206                                                                             |       | 161                             |       | 578 |   | 455 |   |
| Total interest expense on deposits                                          |       | 2,122                                                                           |       | 880                             |       | 5,736 |   | 2,162 |   |
|                                                                        |       |                                                                            |       |                            |       |   |   |   |   |
| Federal funds purchased and securities sold under  agreements to repurchase |       | 686                                                                             |       | —                          |       | 1,198 |   | — |   |
| Junior subordinated deferrable interest debentures                          |       | 396                                                                             |       | 396                             |       | 1,189 |   | 1,189 |   |
| Other borrowings                                                            |       | 183                                                                             |       | 92                              |       | 546 |   | 225 |   |
| Total interest expense                                                      |       | 3,387                                                                           |       | 1,368                           |       | 8,669 |   | 3,576 |   |
| Net interest income before provision (benefit) for  credit losses           |       | 5,861                                                                           |       | 5,386                           |       | 17,543 |   | 15,104 |   |
| Provision  (benefit) for credit losses                                      |       | 72                                                                              |       | (213                            | )          | 144 |   | (124 | ) |
| Net interest income after provision (benefit) for  credit losses            |       | 5,789                                                                           |       | 5,599                           |       | 17,399 |   | 15,228 |   |
| Other operating  income:                                                    |       |                                                                            |       |                            |       |   |   |   |   |
| Trading gain (loss) on non-hedge derivatives                                |       | 550                                                                             |       | (493                            | )          | (267 | ) | (115 | ) |
| International services                                                      |       | 8                                                                               |       | 11                              |       | 62 |   | 37 |   |
| Investment services                                                         |       | 9                                                                               |       | 15                              |       | 28 |   | 44 |   |
| Deposit-related and other customer services                                 |       | 255                                                                             |       | 252                             |       | 721 |   | 818 |   |
| Other noninterest income                                                    |       | 5                                                                               |       | 70                              |       | 77 |   | 286 |   |
| Gain on sale of OREO/fixed assets                                           |       | 1                                                                               |       | —                          |       | 48 |   | — |   |
|                                                                        |       |                                                                            |       |                            |       |   |   |   |   |
| Total other operating income (loss)                                         |       | 828                                                                             |       | (145                            | )          | 669 |   | 1,070 |   |
| Other operating  expenses:                                                  |       |                                                                            |       |                            |       |   |   |   |   |
| Salaries and related benefits                                               |       | 2,131                                                                           |       | 1,998                           |       | 6,413 |   | 5,684 |   |
| Net occupancy                                                               |       | 267                                                                             |       | 257                             |       | 781 |   | 742 |   |
| Furniture and equipment                                                     |       | 136                                                                             |       | 127                             |       | 410 |   | 378 |   |
| Printing and communications                                                 |       | 128                                                                             |       | 128                             |       | 444 |   | 392 |   |
| Insurance and regulatory assessments                                        |       | 87                                                                              |       | 105                             |       | 279 |   | 318 |   |
| Client services                                                             |       | 169                                                                             |       | 152                             |       | 479 |   | 471 |   |
| Computer data processing                                                    |       | 181                                                                             |       | 216                             |       | 607 |   | 666 |   |
| Legal services                                                              |       | 26                                                                              |       | 133                             |       | 120 |   | 589 |   |
| Other professional services                                                 |       | 225                                                                             |       | 287                             |       | 879 |   | 826 |   |
| Other expenses                                                              |       | 183                                                                             |       | 327                             |       | 672 |   | 749 |   |
| Total other operating expenses                                              |       | 3,533                                                                           |       | 3,730                           |       | 11,084 |   | 10,815 |   |
| Net income  before tax provision                                            |       | 3,084                                                                           |       | 1,724                           |       | 6,984 |   | 5,483 |   |
| Provision for  income taxes                                                 |       | 1,328                                                                           |       | 715                             |       | 3,026 |   | 2,275 |   |
| Net income                                                                  |       | $                                                                               | 1,756      |                            | $          | 1,009 |   | $ | 3,958 |   | $ | 3,208 |   |
| Earnings per  share:                                                        |       |                                                                            |       |                            |       |   |   |   |   |
| Basic                                                                       |       | $                                                                               | 0.32       |                            | $          | 0.19 |   | $ | 0.71 |   | $ | 0.74 |   |
| Diluted                                                                     |       | $                                                                               | 0.29       |                            | $          | 0.17 |   | $ | 0.66 |   | $ | 0.55 |   |

 

See accompanying notes to consolidated financialstatements.

4

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** **

**NATIONALMERCANTILE BANCORP AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

(Unaudited)
| ** **                                                                                   | ** ** | **Nine Months Ended September 30,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                   | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
| ** **                                                                                   | ** ** | **(Dollars in thousands)**                    | ** ** |
| Cash flows from  operating activities:                                                       |       |                                                    |       |   |   |
| Net income                                                                                   |       | $                                                       | 3,958      |   | $ | 3,208 |   |
| Adjustments to reconcile net income to net cash  provided by (used in) operating activities: |       |                                                    |       |   |   |
| Depreciation and amortization                                                                |       | 364                                                     |       | 315 |   |
| Provision (benefit) for credit losses                                                        |       | 144                                                     |       | (124 | ) |
| Stock compensation cost                                                                      |       | 290                                                     |       | — |   |
| Gain on sale of other real estate owned                                                      |       | (48                                                     | )          | — |   |
| Net amortization of premium (discount) on securities                                         |       |                                                    |       |   |   |
| available-for-sale                                                                           |       | (193                                                    | )          | 42 |   |
| Net amortization of premium on securities held-to-maturity                                   |       | 14                                                      |       | 24 |   |
| Net amortization of core deposit intangible                                                  |       | 167                                                     |       | 167 |   |
| Net amortization of premium on loans purchased                                               |       | 80                                                      |       | 121 |   |
| Utilization of deferred tax asset                                                            |       | 2,522                                                   |       | 1,822 |   |
| Trading loss on non-hedge derivative                                                         |       | 267                                                     |       | 115 |   |
| Increase in accrued interest receivable and other  assets                                    |       | (1,484                                                  | )          | (1,658 | ) |
| Increase in accrued interest payable and other  liabilities                                  |       | 718                                                     |       | 1,058 |   |
| Net cash provided by operating activities                                                    |       | 6,799                                                   |       | 5,090 |   |
| Cash flows from  investing activities:                                                       |       |                                                    |       |   |   |
| Purchase of securities available-for-sale                                                    |       | (49,682                                                 | )          | (23,531 | ) |
| Proceeds from repayments and maturities of  securities available-for-sale                    |       | 18,408                                                  |       | 3,746 |   |
| Proceeds from repayments and maturities of  securities held-to-maturity                      |       | 439                                                     |       | 688 |   |
| Payment to terminate non-hedge interest rate swap                                            |       | (842                                                    | )          | — |   |
| Loan originations and principal collections, net                                             |       | (19,765                                                 | )          | (17,796 | ) |
| Recoveries of loans previously charged off                                                   |       | —                                                  |       | 1,216 |   |
| Proceeds from sale of other real estate owned                                                |       | 1,104                                                   |       | — |   |
| Net purchase of Federal Reserve Stock and other  stocks                                      |       | (444                                                    | )          | (225 | ) |
| Purchases of premises and equipment                                                          |       | (326                                                    | )          | (351 | ) |
| Net cash used in investing activities                                                        |       | (51,108                                                 | )          | (36,253 | ) |
| Cash flows from  financing activities:                                                       |       |                                                    |       |   |   |
| Net increase in demand deposits, money market and  savings accounts                          |       | 20,669                                                  |       | 10,750 |   |
| Net increase (decrease) in time certificates of  deposit                                     |       | (4,459                                                  | )          | 30,264 |   |
| Net increase in securities sold under agreements to  repurchase                              |       | 45,000                                                  |       | — |   |
| Net decrease in other borrowings                                                             |       | (20,737                                                 | )          | (6,900 | ) |
| Net proceeds from exercise of stock options                                                  |       | 354                                                     |       | 357 |   |
| Cash paid in lieu of fractional shares in 5 for 4  stock split                               |       | (1                                                      | )          | — |   |
| Net cash provided by financing activities                                                    |       | 40,826                                                  |       | 34,471 |   |
| Net increase (decrease) in cash and cash equivalents                                         |       | (3,483                                                  | )          | 3,308 |   |
| Cash and cash equivalents, January 1                                                         |       | 16,192                                                  |       | 16,915 |   |
| Cash and cash equivalents, September 30                                                      |       | $                                                       | 12,709     |   | $ | 20,223 |   |
|                                                                                         |       |                                                    |       |   |   |
| Supplemental  disclosures of cash flow information:                                          |       |                                                    |       |   |   |
| Cash paid for interest                                                                       |       | $                                                       | 7,365      |   | $ | 3,537 |   |
| Cash paid for income taxes                                                                   |       | 1,005                                                   |       | 960 |   |
| Unrealized gain (loss) on securities  available-for-sale, net of tax effect                  |       | 43                                                      |       | (184 | ) |
| Unrealized loss  on cash flow hedges, net of tax effect                                      |       | $                                                       | 30         |   | $ | 638 |   |

 

See accompanying notes to consolidated financialstatements.

5

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**NATIONAL MERCANTILE BANCORP ANDSUBSIDIARIES**

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

NOTE 1—BASIS OFPRESENTATION AND MANAGEMENT REPRESENTATIONS

The unauditedconsolidated financial statements include the accounts of National MercantileBancorp (“National Mercantile” on a parent-only basis, and the ‘‘Company’’ on aconsolidated basis) and its wholly-owned subsidiaries, Mercantile National Bankand South Bay Bank, N.A., (collectively, the “Banks”).  The unaudited consolidated financialstatements of the Company reflect all interim adjustments, which are of anormal recurring nature and which, in management’s opinion, are necessary forthe fair presentation of the Company’s consolidated financial position andresults of operations and cash flows for such interim periods. The results forthe three months and nine months ended September 30, 2006 are not necessarilyindicative of the results expected for any subsequent period or for the fullyear ending December 31, 2006.  Theunaudited consolidated financial statements should be read in conjunction with theaudited consolidated financial statements included in the Company’s AnnualReport on Form 10-KSB/A for the year ended December 31, 2005.

The financial statements,and other financial information, as of December 31, 2005 and for the threemonths and nine months ended September 30, 2005 have been restated.  The restatement corrected errors in theoriginally filed Annual Report on Form 10-KSB and Quarterly Report on Form10-QSB related to the Company’s accounting under Statement of FinancialAccounting Standards 133, Accountingfor Derivative Instruments and Hedging Activities, as amended (“SFAS 133”),for interest rate swap agreements entered into in connection with certaindebentures related to trust preferred securities and subordinated debt.  See Note 11.

NOTE 2—EARNINGSPER SHARE

Basic earnings per shareare computed using the weighted average number of common shares outstandingduring the period. The number of shares has been adjusted for the five-for-fourstock split effected in the form of a dividend paid on April 14, 2006 andreflects the conversion of the Series A Preferred Stock in June 2005.

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

6

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| ** **                                        | ** ** | ** **              | ** ** | **Weighted** | ** ** | ** **         | ** ** |
|---------------------------------------------------|------------|-------------------------|------------|--------------|------------|--------------------|------------|
| ** **                                        | ** ** | ** **              | ** ** | **Average**  | ** ** | **Per Share** | ** ** |
| ** **                                        | ** ** | **Net Income**     | ** ** | **Shares**   | ** ** | **Amount**         | ** ** |
| ** **                                        | ** ** | **(in thousands)** | ** ** | ** **   | ** ** | ** **         | ** ** |
| ** **                                        | ** ** | ** **              | ** ** | ** **   | ** ** | ** **         | ** ** |
| *For the  three months ended September 30, 2006:* |       |                    |       |         |       |               |       |
| Basic EPS                                         |       | $                       | 1,756      |         | 5,545,903  |               | $          | 0.32 |   |
|                                              |       |                    |       |         |       |               |       |
| Effect of dilutive securities:                    |       |                    |       |         |       |               |       |
| Options                                           |       |                    |       | 195,599      |       |               |       |
| Convertible preferred stock                       |       |                    |       | 244,335      |       |               |       |
| Diluted earnings per share                        |       | $                       | 1,756      |         | 5,985,837  |               | $          | 0.29 |   |
|                                              |       |                    |       |         |       |               |       |
| *For the  three months ended September 30, 2005:* |       |                    |       |         |       |               |       |
| Basic EPS                                         |       | $                       | 1,009      |         | 5,408,969  |               | $          | 0.19 |   |
|                                              |       |                    |       |         |       |               |       |
| Effect of dilutive securities:                    |       |                    |       |         |       |               |       |
| Options                                           |       |                    |       | 283,896      |       |               |       |
| Convertible preferred stock                       |       |                    |       | 232,964      |       |               |       |
| Diluted earnings per share                        |       | 1,009                   |       | 5,925,829    |       | $                  | 0.17       |   |
|                                              |       |                    |       |         |       |               |       |
| *For the  nine months ended September 30, 2006:*  |       |                    |       |         |       |               |       |
| Basic EPS                                         |       | $                       | 3,958      |         | 5,535,676  |               | $          | 0.71 |   |
|                                              |       |                    |       |         |       |               |       |
| Effect of dilutive securities:                    |       |                    |       |         |       |               |       |
| Options                                           |       |                    |       | 237,897      |       |               |       |
| Convertible preferred stock                       |       |                    |       | 234,468      |       |               |       |
| Diluted earnings per share                        |       | $                       | 3,958      |         | 6,008,041  |               | $          | 0.66 |   |
|                                              |       |                    |       |         |       |               |       |
| *For the  nine months ended September 30, 2005:*  |       |                    |       |         |       |               |       |
| Basic EPS                                         |       | $                       | 3,208      |         | 4,350,700  |               | $          | 0.74 |   |
|                                              |       |                    |       |         |       |               |       |
| Effect of dilutive securities:                    |       |                    |       |         |       |               |       |
| Options                                           |       |                    |       | 260,090      |       |               |       |
| Convertible preferred stock                       |       |                    |       | 1,263,081    |       |               |       |
| Diluted earnings  per share                       |       | $                       | 3,208      |         | 5,873,871  |               | $          | 0.55 |   |

NOTE 3—CASH ANDCASH EQUIVALENTS

Forpurposes of reporting cash flows, cash and cash equivalents include cash, due frombanks-interest-bearing and federal funds sold, all with maturities of threemonths or less.

NOTE 4—ALLOWANCEFOR CREDIT LOSSES 

Theallowance for loan and lease losses is a valuation adjustment used to recognizeimpairment of the recorded investment in the Company’s loans receivable on itsbalance sheet before losses have been confirmed resulting in subsequentcharge-offs or write-downs.

7

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Provisionsfor credit losses charged (or credited) to operations reflect management’sjudgment of the adequacy of the allowance for loan and lease losses and aredetermined through periodic analysis of the loan portfolio.  This analysis includes a systematic anddetailed review of the classification and categorization of problem loans; anassessment of the overall quality and collectibility of the portfolio; andconsideration of the loan loss experience, trends in problem loans,concentrations of credit risk, as well as current economic conditions(particularly Southern California). Management performs a periodic risk and credit analysis, the results ofwhich are reported to the Board of Directors.

Duringthe third quarter 2006, the Company charged off loans totaling $21,000 andrecovered no loans previously charged off. Pursuant to management’s evaluation of the allowance for loan and leaselosses at September 30, 2006, a provision for credit losses of $72,000 and$144,000 was recorded for the three months and nine months ended September 30,2006, respectively.  There was a $213,000benefit for credit losses recorded during the third quarter 2005 and $124,000benefit for the nine months ended September 30, 2005.

The following table sets forth information concerningthe Company’s allowance for credit losses for the periods indicated.

|                                                                           | ** ** | **Nine Months Ended**      | ** ** |
|---------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                | ** ** | **September 30,**               | ** ** |
| ** **                                                                | ** ** | **2006**                             | ** ** | **2005** | ** ** |
| ** **                                                                | ** ** | **(Dollars in thousands)** | ** ** |
|                                                                      |       |                                 |       |   |   |
| Balance,  beginning of period                                             |       | $                                    | 4,468      |   | $ | 3,511 |   |
| Total loans charged-off                                                   |       | 22                                   |       | 6 |   |
| Total recoveries of loans previously charged off                          |       | —                               |       | 1,216 |   |
| Net charge-offs (recoveries)                                              |       | 22                                   |       | (1,210 | ) |
| Provision (benefit) for credit losses                                     |       | 144                                  |       | (124 | ) |
| Transfer (to) from reserve for contingent losses on  unfunded commitments |       | 71                                   |       | (71 | ) |
| Balance, end of  period                                                   |       | $                                    | 4,661      |   | $ | 4,526 |   |

 

Creditquality is affected by many factors beyond the control of the Company,including local and national economies, and facts may exist which are not knownto the Company that adversely affect the likelihood of repayment of variousloans in the loan portfolio and realization of collateral upon a default.  Accordingly, no assurance can be given thatthe Company will not sustain loan losses materially in excess of the allowancefor credit losses. In addition, the Office of the Comptroller of the Currency (“OCC”),as an integral part of its examination process, periodically reviews theallowance for credit losses and could require additional provisions for creditlosses.

8

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NOTE5—GOODWILL AND CORE DEPOSIT INTANGIBLES

Asof September 30, 2006 and December 31, 2005 the Company had goodwill of $3.2million, and net core deposit intangibles of $1.2 million and $1.4 million,respectively, from its acquisition of South Bay Bank in December 2001.  The gross carrying amount of core depositintangibles was $2.3 million at September 30, 2006 and December 31, 2005, andaccumulated amortization was $1.1 million and $900,000, respectively, at suchdates.  The core deposit intangibles areestimated to have a life of 10 years and 4 months.  Amortization for intangibles for 2006 andeach of the next four years is estimated to be $223,000 per year.  In accordance with SFAS No. 142 goodwill isnot amortized.  The Company has no otherrecorded indefinite-lived intangible assets. Goodwill and other intangible assets are reviewed and assessed annuallyfor impairment or more frequently if conditions suggest impairment may exist.

NOTE 6—REPURCHASEAGREEMENTS

AtSeptember 30, 2006, the Company had $45.0 million of securities sold underagreement to repurchase (“Repurchase Agreements”).  At December 31, 2005, there were noRepurchase Agreements.  The RepurchaseAgreements are adjustable, indexed to LIBOR, and contain embedded interest ratefloors with various strike rates for terms ranging two- to three-years and wereutilized to facilitate the Company’s liquidity and interest rate riskmanagement objectives.  In the event of asustained decline in interest rates, upon reaching the strike rate, the cost ofthe Repurchase Agreements will decline at double the difference between theindex rate and the strike rate, but in any event, not below zero.

Theembedded interest rate floors have not been separated from the RepurchaseAgreements and accounted for as a derivative instrument because (i) the strikerate was below the LIBOR index at issuance of the Repurchase Agreements and itis clearly and closely related to the economic characteristics and risks of theRepurchase Agreements, and (ii) the Repurchase Agreements are not remeasured atfair value under otherwise applicable generally accepted accounting principleswith changes in fair value reported in earnings.

NOTE 7—INCOMETAXES

Provisionfor income taxes of $1.3 million and $715,000 were recorded for the threemonths ended September 30, 2006 and 2005, respectively.  Income tax provisions of $3.0 million and$2.3 were recorded for the nine months ended September 30, 2006 and 2005,respectively.

AtSeptember 30, 2006, the Company had federal alternative minimum tax “AMT”credits of $637,000 that carry forward indefinitely.

 

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NOTE 8—SHARE-BASEDPAYMENTS

At September 30, 2006, the Company had one stockincentive plan pursuant to which up to a total of 312,500 shares of commonstock may be issued.  Under this plan, the Company may grant to directors,officers, employees and consultants stock-based incentive compensation in avariety of forms, including without limitation nonqualified options, incentiveoptions, sales and bonuses of common stock and stock appreciation rights, onsuch terms and conditions as the Board of Directors of the Companydetermines.  The term of the stock option may not exceed 10 years. Employee stock option grants generally vest over one year or ratable over twoyears.  Director stock options vest in one year.  All stock optionshave vesting conditions that include only service conditions; none of thegrants contains performance or market vesting conditions.

The Company issues new shares upon the exercise ofstock options.  All of the share-based payment awards qualify forclassification as equity.  At September 30, 2006, the only outstandingawards under this plan were stock options, and at that date 195,088 shares wereavailable for future awards.  At September 30, 2006, there were alsooutstanding options granted under two prior stock incentive plans. The activityof stock options for the nine months ended September 30, 2006 is as shown:
| ** **                       | ** ** | **No. of   Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|----------------------------------|------------|-------------------------------|------------|--------------------------------------------|------------|-----------------------------------------------------|------------|-------------------------------------|------------|
| Outstanding, December  31, 2005  |       | 519,358                       |       | $                                          | 9.62       |                                                | 6.3        |                                | $          | 1,365,912 |   |
| Granted                          |       | 6,975                         |       | 15.00                                      |       |                                                |       | (19,185                             | )          |
| Exercised                        |       | (39,815                       | )          | 7.51                                       |       |                                                |       | 188,841                             |       |
| Forefeited                       |       | (11,750                       | )          | 12.63                                      |       |                                                |       | 4,493                               |       |
| Expired                          |       | —                        |       | —                                     |       |                                                |       | —                              |       |
| Five-for-four  stock split       |       | 119,341                       |       | n/a                                        |       |                                                |       | n/a                                 |       |
| Outstanding, September  30, 2006 |       | 594,109                       |       | $                                          | 7.81       |                                                | 6.0        |                                | 2,637,842  |   |
|                             |       |                          |       |                                       |       |                                                |       |                                |       |
| Exercisable, September 30, 2006  |       | 494,176                       |       | $                                          | 7.25       |                                                | 5.0        |                                | 2,468,772  |   |
|                                  |            |                               |            |                                            |            |                                                     |            |                                     |            |  |  |

 

The Financial Accounting Standards Board issuedStatement of Financial Accounting Standards No. 123R, “Share-Based Payment”(SFAS 123R) which eliminated the ability to account for share-basedcompensation transactions, including grants of employee and director stockoptions, using Accounting Principles Board Opinion No. 25, “Accounting forStock Issued to Employees” (APB 25), and generally requires that such transactionsbe accounted for using a fair value-based method with the resultingcompensation cost recognized over the period that the employee or director isrequired to provide service in order to receive their compensation.  TheCompany adopted SFAS 123R as of January 1, 2006 utilizing the modifiedprospective application.  Under this method, the provisions of SFAS 123Rare applied to new awards and to awards modified, repurchased or canceled afterDecember 31, 2005 and to awards outstanding on December 31, 2005 for which therequisite service has not yet been rendered.  Prior to December 31, 2005,the Company accounted for its stock options using the intrinsic value method, 

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as prescribed by APB 25, and accordingly, no expensefor stock options was recorded in periods ending on or prior to December 31,2005.

For the three months and nine months ended September30, 2006, share-based compensation expense was $105,000 and $290,000respectively, resulting in similar charges to net income before income tax andnet income for the periods. The share-based compensation expense decreased bothbasic and diluted earnings per share by $0.02 for the quarter ended September30, 2006 and $0.05 for the nine months ended September 30, 2006.  Theincome tax benefit for the nine months ended September 30, 2006 was immaterialas nearly all unvested stock options were qualified incentive stockoptions.  For the nine months ended September 30, 2006, there was noimpact to cash flow from financing activities as there were no tax deductionsthat exceeded the compensation cost for share-based payments.

The reported net income and earnings per share for thethree months and  nine months ended September 30, 2005 are presented belowto reflect the impact had the Company been required to recognize compensationexpense based on SFAS 123R:
| ** **                                                                                                                            | ** ** | **Three Months Ended  September 30,**                        | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                                            | ** ** | **2005**                                                                    | ** ** | **2005**                                            | ** ** |
| ** **                                                                                                                            | ** ** | **(Dollars in thousands,  except per share data)** | ** ** |
| Net income:                                                                                                                           |       |                                                                        |       |                                                |       |
| As reported                                                                                                                           |       | $                                                                           | 1,009      |                                                | $          | 3,208 |   |
| Total stock-based employee compensation expense  determined under fair value based method for all awards, net of related tax  effects |       | 90                                                                          |       | 190                                                 |       |
| Pro forma                                                                                                                             |       | $                                                                           | 919        |                                                | $          | 3,018 |   |
|                                                                                                                                  |       |                                                                        |       |                                                |       |
| Income per share as reported:                                                                                                         |       |                                                                        |       |                                                |       |
| Basic                                                                                                                                 |       | $                                                                           | 0.19       |                                                | $          | 0.74 |   |
| Diluted                                                                                                                               |       | 0.17                                                                        |       | 0.55                                                |       |
| Income per share pro forma:                                                                                                           |       |                                                                        |       |                                                |       |
| Basic                                                                                                                                 |       | $                                                                           | 0.17       |                                                | $          | 0.69 |   |
| Diluted                                                                                                                               |       | 0.16                                                                        |       | 0.51                                                |       |

 

The estimated per share weighted average fair value ofoptions granted during the nine months ended September 30, 2006 was $4.77.  The estimated per share weighted average fairvalue of options granted in the nine months ended September 30, 2005 was $5.73.

Under the fair value method, stock option compensationexpense is measured on the date of grant using an option-pricing model. Upon adoption of SFAS 123R, the fair values of the stock options were estimatedusing a lattice option pricing model.   Previously, the fair valuesof stock options were estimated using the Black-Scholes option-pricingmodel.  Due to longer contractual terms of the Company’s stock optionsthan traded options, suboptimal exercise patterns and risk-free interest 

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rates and dividend rates that may be expected todiffer over the option term from the grant date, the lattice option pricingmodel better reflects the substantive characteristics of the Company’s stockoptions.  The effect of the change to the lattice option pricing model didnot have a material impact on the current period.

The lattice option pricing models require certainassumptions.  For the nine months ended September 30, 2006, the expectedvolatility assumption of 32.0% is based upon the weekly historical volatilityof the Company’s stock price for the period January 1, 2000 through December31, 2005 using a blend of the unweighted standard deviation of closing pricewith a weighted mean reversion formula.  The risk-free interest rateassumption ranged from 4.46% to 5.00% for the expected term of the shareoptions and is based upon the U.S. Treasury implied forward yield curve at thetime of the grant.  The dividend yield assumption ranged from 0 to 2.5%during the expected term of the options and is based upon the Company’s capitalplanning model.  The assumptions used with the Black-Sholes option pricingmodel, for the nine months ended September 30, 2005, are as follows:  expected volatility 43%, expected term 10years, risk-free interest rate 4.38%; and dividend yield 0%.

NOTE9—COMPREHENSIVE INCOME

Comprehensive income is the change in equity during aperiod from transactions and other events and circumstances from nonownersources.  The accumulated balance ofother comprehensive income (loss) is required to be displayed separately fromretained earnings in the consolidated balance sheet.  Total comprehensive income was as follows:
| ** **                                                                          | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30, ** | ** ** |
|-------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                                          | ** ** | **2006**                                             | ** ** | **2005**                                                  | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                          | ** ** | **(Dollars in thousands)**                 | ** ** | ** (Dollars in thousands) **          | ** ** |
| Net income                                                                          |       | $                                                    | 1,756      |                                                      | $          | 1,009 |   | $ | 3,958 |   | $ | 3,208 |   |
| Other  comprehensive income (loss) before tax, and unrealized losses on securities: |       |                                                 |       |                                                      |       |   |   |   |   |
| Unrealized gain (loss) on interest rate swaps used  in cash flow hedges             |       | 761                                                  |       | (896                                                      | )          | (60 | ) | (1,266 | ) |
| Unrealized gain (loss) on interest rate floors used  in cash flow hedges            |       | 29                                                   |       | (151                                                      | )          | (219 | ) | (176 | ) |
| Unrealized gain (loss) on securities available for  sale                            |       | 2,295                                                |       | (281                                                      | )          | 90 |   | (315 | ) |
| Other comprehensive income (loss), before tax                                       |       | 3,085                                                |       | (1,328                                                    | )          | (189 | ) | (1,757 | ) |
| Income tax  benefit (expense) related to items of other comprehensive income        |       | (1,256                                               | )          | 551                                                       |       | (103 | ) | 730 |   |
| Other comprehensive income (loss)                                                   |       | 1,829                                                |       | (777                                                      | )          | (292 | ) | (1,027 | ) |
| Total comprehensive income                                                          |       | $                                                    | 3,585      |                                                      | $          | 232 |   | $ | 3,666 |   | $ | 2,181 |   |

 

NOTE 10—DERIVATIVE FINANCIAL INSTRUMENTS

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The Company holds fixed rate and variable ratefinancial assets that are funded by fixed rate and variable rateliabilities.  Consequently, they aresubject to the effects of changes in interest rates.  In response to this, the Company hasdeveloped an interest rate risk management policy with the objective ofmitigating financial exposure to changing interest rates.  These exposures are managed, in part, withthe use of derivatives but only to the extent necessary to meet the overallgoal of minimizing interest rate risk.

Derivatives are accounted for according to SFAS No.133, Accounting for Derivative Instruments and Hedging Activities, as amended.This standard requires that all derivative instruments be recognized in thefinancial statements and measured at fair value regardless of the purpose orintent for holding them.  To qualify forhedge accounting, the details of the hedging relationship must be formallydocumented at inception of the arrangement, including the risk managementobjective, hedging strategy, hedged item, specific risks that are being hedged,the derivative instrument and how effectiveness is being assessed.  The derivative must be highly effective inoffsetting either changes in fair value or cash flows, as appropriate, for therisk being hedged.  Effectiveness isevaluated on a retrospective and prospective basis. If a hedge relationshipbecomes ineffective, it no longer qualifies as a hedge. Any excess gains orlosses attributable to such ineffectiveness, as well as subsequent changes inthe fair value of the derivative, are recognized in earnings.

The following is a summary of our risk managementstrategies and the effect of these strategies on the consolidated financialstatements.

**Derivative Financial Instrumentsand Hedging Activities**

 
| ** **                   | ** ** | **September 30, 2006**     | ** ** | **December 31, 2005** | ** ** |
|------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **                   | ** ** | **Notional  Amount**                 | ** ** | **Fair Value**             | ** ** | **Notional  Amount** | ** ** | **Fair Value** | ** ** |
| ** **                   | ** ** | **(Dollars in thousands)** | ** ** |
|  Fair value hedges:     |       |                                 |       |                            |       |   |   |   |   |
|  Interest rate  swaps   |       | $                                    | 50,000     |                            | $          | (47 | ) | $ | 30,000 |   | $ | 41 |   |
|                         |       |                                 |       |                            |       |   |   |   |   |
|  Cash flow hedges:      |       |                                 |       |                            |       |   |   |   |   |
|  Interest rate  swaps   |       | $                                    | 50,000     |                            | $          | (1,093 | ) | $ | 50,000 |   | $ | (1,034 | ) |
|  Interest rate  floors. |       | $                                    | —     |                            | $          | — |   | $ | 50,000 |   | $ | 286 |   |
|                         |       |                                 |       |                            |       |   |   |   |   |
|  Non-hedge derivatives: |       |                                 |       |                            |       |   |   |   |   |
|  Interest rate  floors  |       | $                                    | 50,000     |                            | $          | 29 |   | $ | 150,000 |   | $ | — |   |
|  Interest rate swaps    |       | —                               |       | —                          |       | $ | 15,000 |   | $ | (575 | ) |

 

Fair value hedges are hedges that minimize the risk ofchanges in the fair values of assets, liabilities and certain types of firmcommitments.  The Company uses interestrate swaps to hedge the change in fair value of its brokered certificates ofdeposit.  The interest rate swaps resultin the Company paying or receiving the difference between the fixed and floatingrates 

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at specified intervals calculated on the notionalamounts.  The differential paid orreceived on such interest rate swaps are recognized as an adjustment tointerest expense.  The net change in fairvalue of the derivatives and the hedged items is reported in earnings.  The fair value hedges are highly effectiveand therefore no ineffectiveness was recognized in current earnings related tothis swap.

Cash flow hedges are hedges that use simplederivatives to offset the variability of expected future cash flows.  The Company’s cash flow hedges includecertain interest rate swaps and interest rate floors used to manage theinterest rate risk associated with its significant volume of adjustable rateloans.  At September 30, 2006 a loss of$793,000 was recorded in accumulated other comprehensive loss withinshareholders’ equity and no ineffectiveness was recorded to earnings for thenine months ended September 30, 2006 related to these cash flow hedges.  The premiums paid for the interest ratefloors are amortized over the life of the floors.

Other economic derivatives not designated as hedgesare interest rate swaps and interest rate floors that do not meet the strictcriteria for hedge accounting treatment. The Company does not utilize derivatives for purely speculativepurposes.  The Company uses derivativesto hedge exposures when it makes economic sense to do so, including thecircumstances in which the hedging relationship does not qualify for hedgeaccounting.  At September 30, 2006 theCompany had other interest rate floors to hedge the cash flows of itsadjustable rate loans that were not designated as a hedge.  Derivativesnot designated as hedges are marked-to-market through earnings as a tradinggain or loss on economic derivatives.

Additionally, during the third quarter 2006 theCompany terminated its position in a $15.0 million interest rate swap that wasused to hedge the fair value of its junior subordinated deferrable interestdebentures.  The swap was not designatedas a hedge. A trading gain on non-hedge derivatives of $550,000 was recordedfor the third quarter and a trading loss of $267,000 was recorded for the ninemonths ended September 30, 2006. The following table reflects the effect of thetrading gains and losses on economic derivatives for the periods shown:
| ** **                                                         | ** ** | **Three Months Ended**     | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **                                                         | ** ** | **September 30,**               | ** ** | **September 30,**          | ** ** |
| ** **                                                         | ** ** | **2006**                             | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                         | ** ** | **(Dollars in thousands)** | ** ** |
| Trading gain  (loss) on non-hedge derivatives, gross               |       | $                                    | 550        |                            | $          | (493 | ) | $ | (267 | ) | $ | (115 | ) |
| Income tax  expense (benefit) related to non-hedge derivatives.    |       | 228                                  |       | (205                            | )          | (111 | ) | (48 | ) |
| Trading gain (loss) on  non-hedge derivatives, net of income taxes |       | $                                    | 322        |                            | $          | (288 | ) | $ | (156 | ) | $ | (67 | ) |

 

NOTE 11 — RESTATEMENT

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The financial statements as of December 31, 2005 andSeptember 30, 2005, and for the nine months then ended, have beenrestated.  The restatement corrects errors in the financial statementsrelated to the Company’s accounting under SFAS 133, for the interest rate swapagreement entered into in connection with certain debentures related to trustpreferred securities and the related subordinated debt (“Debt Transactions”).

In August 2006, the Company became aware that, inlight of recent informal technical interpretations, its application of hedgeaccounting under paragraph 68 of SFAS No. 133 (commonly referred to as the“short-cut” method) for the interest rate swap on its Debt Transactions may notbe correct. After further examination and discussions with its auditors, theCompany concluded that the swap transaction did not qualify for the short-cutmethod of hedge accounting because of the interest deferral feature of thetrust preferred securities.  SFAS 133 does not allow for application ofthe “long-haul” method retrospectively.  Consequently, the swap did notqualify for hedge accounting and was marked-to-market from its inception, withthe result that changes in the market value of the interest rate swap has beenrecorded through the income statement. There is no effect on cash flows fromthese revisions.

Thefollowing table shows the effect of the restatement as of December 31, 2005:
| ** **                                     | ** ** | **December 31, 2005**      | ** ** |
|------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                     | ** ** | **As Originally Reported** | ** ** | **As Restated** | ** ** |
| ** **                                     | ** ** | **(Dollars in thousands)** | ** ** |
| Deferred tax  asset, net                       |       | $                                    | 4,203      |   | $ | 4,442 |   |
| Accrued interest  receivable and other assets. |       | 4,583                                |       | 4,008 |   |
| Total assets                                   |       | 448,796                              |       | 448,460 |   |
| Accumulated  deficit                           |       | (7,044                               | )          | (7,380 | ) |
| Total shareholders’  equity.              |       | 38,499                               |       | 38,163 |   |
|                                                |            |                                      |            |  |  |  |  |

 

Thefollowing table shows the effect of the restatement for the periods shown:

15

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| ** **                                              | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|---------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                              | ** ** | **September 30, 2005** | ** ** | **September 30, 2005** | ** ** |
| ** **                                              | ** ** | **As  Originally  Reported**     | ** ** | **As Restated**             | ** ** | **As  Originally  Reported** | ** ** | **As Restated** | ** ** |
|                                                    |       |                             |       |                             |       |   |   |   |   |
| Net interest  income before provision for credit losses |       | $                                | 5,456      |                             | $          | 5,456 |   | $ | 15,390 |   | $ | 15,390 |   |
| Net cash  settlement of interest rate swap derivative   |       | —                           |       | (70                              | )          | — |   | (286 | ) |
| Total net interest income                               |       | 5,456                            |       | 5,386                            |       | 15,390 |   | 15,104 |   |
| Provision  (benefit) for credit losses                  |       | (213                             | )          | (213                             | )          | (124 | ) | (124 | ) |
| Net interest income after provision for credit  losses  |       | 5,669                            |       | 5,599                            |       | 15,514 |   | 15,228 |   |
| Total other  operating income                           |       | 278                              |       | 278                              |       | 899 |   | 899 |   |
| Net cash settlement of interest rate swap derivative    |       | —                           |       | 70                               |       | — |   | 286 |   |
| Change in fair value of interest rate swap  derivative  |       | —                           |       | (493                             | )          | — |   | (115 | ) |
| Total non-interest income                               |       | 278                              |       | (145                             | )          | 899 |   | 1,070 |   |
| Total other  operating expenses                         |       | 3,730                            |       | 3,730                            |       | 10,815 |   | 10,815 |   |
| Income before taxes                                     |       | 2,217                            |       | 1,724                            |       | 5,598 |   | 5,483 |   |
| Income tax  expense                                     |       | 920                              |       | 920                              |       | 2,323 |   | 2,323 |   |
| Income tax effect on restatement                        |       | —                           |       | (205                             | )          | — |   | (47 | ) |
| Total income tax expense                                |       | 920                              |       | 715                              |       | 2,323 |   | 2,275 |   |
| Net income                                              |       | $                                | 1,297      |                             | $          | 1,009 |   | $ | 3,275 |   | $ | 3,208 |   |
|                                                    |       |                             |       |                             |       |   |   |   |   |
| Net income per  share — Basic                      |       | $                                | 0.24       |                             | $          | 0.19 |   | $ | 0.75 |   | $ | 0.74 |   |
| Net income per share —  Diluted                    |       | $                                | 0.22       |                             | $          | 0.17 |   | $ | 0.56 |   | $ | 0.55 |   |

 

NOTE 12—AGREEMENT ANDPLAN OF MERGER

On June 15, 2006, National Mercantile enteredinto an Agreement and Plan of Merger (the “Merger Agreement”) with FCB Bancorp,a California corporation (“FCB”), and First California FinancialGroup, Inc. (“FCFG”), a new Delaware corporation formed by NationalMercantile for the purpose of the merger transactions.  The MergerAgreement provides for the reincorporation merger of National Mercantile intoFCFG immediately followed by the merger of FCB into FCFG (together, the “Mergers”).

Consummation of the Mergers is subject to a number ofclosing conditions, including approval by the shareholders of both NationalMercantile and FCB and regulatory approval.

NOTE 13—RECLASSIFICATIONS

Certain prior yeardata has been reclassified to conform to the current year presentation.

 

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***Item2.******                      MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS***

National Mercantile Bancorp (“National Mercantile” ona parent-only basis, and the ‘‘Company’’ or “we” on a consolidated basis) isthe holding company for two subsidiary banks, Mercantile National Bank (“Mercantile”)and South Bay Bank, N.A. (“South Bay”) (collectively, “the Banks”).  National Mercantile’s principal assets arethe capital stock of Mercantile and South Bay. The per share data reflects the five-for-four stock split paid April 14,2006 to shareholders of record March 31, 2006 as well as the conversion of theSeries A Preferred stock to common stock in June 2005.

**RESULTSOF OPERATIONS OVERVIEW**

The Company recorded net income of $1.8 million, or$0.32 basic earnings per share and $0.29 diluted earnings per share, for thethree months ended September 30, 2006 compared to net income of $1.0 million,or $0.19 basic earnings per share and $0.17 diluted earnings per share, for thesame period of 2005.   The increase innet income for the third quarter of 2006 was attributable to (i) a $475,000increase in net interest income before the provision for credit lossesresulting from increases in the prime rate lending index, a greater volume ofinterest earning assets, particularly higher-yielding loans receivable andsecurities available-for-sale, (ii) a $973,000 increase in other operatingincome as a result of a $550,000 trading gain on non-hedge derivatives comparedto a $493,000 charge for the 2005 period, and (iii) a $197,000 decrease inother operating expenses.  Thesefavorable changes were partially offset by a $613,000 increase in provision forincome taxes and a $285,000 increase in provision for loan losses resultingfrom a $72,000 charge in the 2006 quarter compared to a $213,000 benefit forcredit losses in the third quarter 2005 resulting from the recovery of loanspreviously charged off.  Additionally,the Company adopted Statement of Financial Accounting Standards No. 123R,Stock-Based Payments (SFAS 123R), January 1, 2006 resulting in the recognitionof compensation expense for unvested stock options and an after-tax charge of$105,000 for the three months ended September 30, 2006.  There was no SFAS 123R charge for the 2005quarter.

The Company recorded net income of $4.0 million, or$0.71 basic earnings per share and $0.66 diluted earnings per share, for thenine months ended September 30, 2006 compared to net income of $3.2 million, or$0.74 basic earnings per share and $0.55 diluted earnings per share, for thesame period of 2005. The increase in net income for the 2006 period wasprimarily due to a $2.4 million increase in net interest income beforeprovision for credit losses resulting from increases in the prime rate lendingindex, interest rate swaps, a greater volume of interest earning assets,particularly higher-yielding loans receivable and securitiesavailable-for-sale. This positive change was partially offset by (i) a $751,000increase in provision for income taxes, (ii) a $401,000 decrease in otheroperating income, (iii) a $269,000 increase in other operating expenses, and(iv) a $268,000 

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increase in provision for loan losses.  The SFAS 123R after-tax charge for stockoptions for the nine months ended September 30, 2006 was $290,000.  There was no such charge for the 2005 period.

Return on average assets during the third quarter andfirst nine months of 2006 was 1.43% and 1.10%, respectively, compared to 0.99%and 1.09% during the third quarter and first nine months of 2005, respectively.  Return on average equity during the thirdquarter and first nine months of 2006 was 17.05% and 13.27%, respectively,compared to 10.72% and 11.83% during the third quarter and first nine months of2005, respectively.

NET INTERESTINCOME

*ThirdQuarter*

Net interest income before the provision for creditlosses increased $475,000 to $5.9 million for the three months ended September30, 2006 compared to the same quarter of 2005 due to a $2.5 million increase intotal interest income partially offset by a $2.0 million increase in interestexpense.  Loan interest income increased$1.5 million due to a $33.0 million greater average volume of loans receivableand a 102 basis point increase in yield, resulting primarily from increases inthe prime rate lending index.  Thegreater loan volume was primarily due to the more rapid funding of constructionloans originated in earlier periods and fewer payoffs of commercial real estateloans. During 2005, the Federal Reserve Bank increased the target federal fundsrate 200 basis points on eight occasions and, continuing into the first half of2006, another 100 basis points on four occasions. Approximately 70% of our$358.2 million loans receivable have adjustable interest rates; consequently,rising interest rates positively affect interest income for these earningassets. Conversely, declining interest rate environments have the potential tonegatively impact our net interest income. In order to reduce the negative impact in the event of a decline in theprime rate lending index, among other techniques, we have entered into interestrate swaps in which we exchanged an adjustable rate interest payment based onthe prime rate for a fixed payment on an aggregate notional amount of $50.0million.  The higher yields earned on ourloans receivable during the third quarter of 2006 were partially offset by therising cost of the interest rate swaps.

Interest income from securities available-for-saleincreased $890,000 during the third quarter 2006 compared to the third quarter2005 due to a $44.9 million increase in average volume and a 188 basis pointincrease in yield.  At September 30, 2006securities available-for-sale were $103.3 million, an increase of $31.6 millionfrom December 31, 2005.  During the thirdand fourth quarters of 2005 and continuing into 2006, we have steadily addednewly purchased securities to our investment portfolio as part of a strategy tofurther reduce the exposure of net interest income to a declining interest rateenvironment. The additions to securities have been instruments that we expectto have limited prepayment of principal in the event of declining interestrates (and muted term extension in rising interest rates).  These investments, as well as loans receivable,have been 

18

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largely financed with adjustable rate wholesale fundsthat will decline in cost in a falling interest rate environment. The morerecently purchased securities, during the period of higher interest rates, andthe maturity of lower yielding securities in the portfolio, resulted in anincrease in the securities portfolio yield.

Overall, interest-earning assets averaged $81.3million greater during the third quarter 2006 than third quarter 2005 and thehigher yields and favorable change in composition to higher-yielding assets resultedin a 89 basis point increase in weighted average yield on interest-earningassets.

Interest expense increased $2.0 million for the threemonths ended September 30, 2006 compared to the same period in 2005, due to a$91.0 million increase in interest-bearing liabilities and a 180 basis pointincrease in cost of funds.  Interestexpense on deposits increased $1.2 million due to a 162 basis point rise inweighted average cost of interest-bearing deposits in addition to $45.4 milliongreater average volume than 2005.  Timecertificates of deposit $100,000 and over averaged $34.3 million greater duringthe third quarter 2006 than the same period in 2005 due to an increased volumeof brokered certificates of deposit (“Brokered CDs”).  The volume of money market and savingsdeposits increased $16.0 million during the third quarter of 2006 compared to2005 period while time certificates of deposit under $100,000 declined $1.2million.

During the rising interest rate environmentexperienced during the past nine quarters, we strategically elected to onlymoderately increase transaction deposit rates and to fund runoff of thesedeposits, as well as asset growth, with Brokered CDs.  Although this type of funding is typically highercosting and exhibits higher interest rate sensitivity, the Brokered CDsfacilitate our liquidity and interest rate risk management that we utilize toreduce our net interest income exposure to possible declining interestrates.  The greater interest expense onthe incremental Brokered CDs needed to fund asset growth is less than theimpact of increasing rates on the significantly greater volume of transactionaccounts.  As market interest ratescontinue to rise, the cost of our deposits has been increasing more rapidly dueto more frequent exceptions to our posted interest rates granted to depositorsin order to prevent deposit withdrawals and to generate new deposits.

The cost of time certificates of deposit $100,000 andover increased 179 basis points during the third quarter of 2006 compared tothe same quarter 2005.  The cost of moneymarket and savings deposits increased 177 basis points while the cost ofinterest-bearing demand deposits and time certificates of deposit under$100,000 increased 28 basis points and 88 basis points, respectively.

The volume of other borrowings averaged $12.3 millionand $9.9 million during the third quarter of 2006 and 2005, respectively.   We continue to employ a liquidity strategyof maintaining relatively low levels of short-term assets and utilizing FederalHome Loan Bank overnight advances, against pledged loans and securities, toadjust our funding of asset and deposit volume changes.  Minimizing short-term assets and increasingshort-term liabilities furthers the interest rate risk management 

19

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of our asset sensitive balance sheet. The cost ofother borrowings was 5.92% and 3.68% for the 2006 and 2005 periods,respectively, representing an increase of 224 basis points for the thirdquarter of 2006.

Securities sold under agreement to repurchase (“RepurchaseAgreements”) averaged $43.3 million during the third quarter of 2006 with acost of 6.29%.  The RepurchaseAgreements, totaling $45 million at September 30, 2006 with adjustable interestrate based upon the 3-month LIBOR index, have embedded floors with varyingstrike rates ranging from 4.00% to 4.75%, advancing our interest rate riskmanagement objectives.  In the event thatthe LIBOR index declines below the strike rate, the cost of the RepurchaseAgreements will decline at double the difference between the LIBOR index andthe strike rate.   We had no RepurchaseAgreements during 2005.

Noninterest-bearing demand deposits averaged $114.8million during the third quarter 2006 or $13.7 million less than during thesame quarter in 2005.  Rising interest ratesincrease depositors’ opportunity cost of noninterest-bearing deposits and theirsensitivity to maintaining such balances, resulting in the redeployment oftheir funds into higher yielding deposits and alternative investments outsidethe Banks.

The net yield on interest earning assets (net interestmargin) was 5.09% and 5.69% during the third quarter in 2006 and 2005,respectively, while the net interest spread was 3.95% and 4.86%,respectively.  The net interest marginand net interest spread during the third quarter of 2006 have declined fromrecent quarters largely due to the securities leverage strategy —intermediate-term security purchases financed with adjustable wholesale funds —executed to reduce our balance sheet asset sensitivity. While the strategyprotects against a possible decline in interest rates, the current margin onsuch leverage is relatively thin.  Also,the third quarter of 2006 continued to experience a flat or inverted yieldcurve in which short-term rates have risen to or above the level of long-terminterest rates.  A preponderance of ourfunding sources is correlated to the short-term rates. Additionally, the netinterest spread has been affected by a decline in net earning assets due to alower proportion of noninterest-bearing deposits funding earning assets.

*Nine-Months*

Net interest income increased $2.4 million to $17.5million for the nine months ended September 30, 2006 compared to the sameperiod of 2005 due to a $7.5 million increase in interest income offset by a$5.1 million increase in interest expense.

Loan interest income increased $5.0 million to $22.3million due to $40.1 million greater average volume of loans receivable and a106 basis point increase in yield, resulting primarily from increases in theprime rate lending index.  The higheryields earned on our loans receivable during the first three quarters 2006 werepartially offset by the rising cost of the interest rate swaps.

Interest income from securities available-for-saleincreased $2.5 million to $3.6 million during the first three quarters of 2006compared to the same period of 2005 due to $48.9 million greater average volumeand a 169 basis point increase in yield.

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As discussed above, wehave been steadily adding to securities available-for-sale and the morerecently purchased securities, in a period of higher interest rates, resultedin an increase in the portfolio yield.

Overall, interest-earning assets were $88.7 milliongreater during the 2006 period than 2005 while the higher interest rates andfavorable change in composition to higher-yielding assets resulted in a 88basis point increase in weighted average yield on interest-earning assets.

Interest expense increased $5.1 million during thefirst three quarters of 2006 compared to the same period in 2005 due to a $91.2million increase in average interest-bearing liabilities and a 153 basis pointincrease in the weighted average cost of interest-bearing liabilities.  Interest expense on deposits increased $3.6 milliondue to a 152 basis point rise in weighted average cost of interest-bearingdeposits in addition to $56.6 million greater average volume than 2005.  Time certificates of deposit $100,000 andover averaged $40.3 million greater during the 2006 period than 2005 due to anincreased volume of Brokered CDs.  Theaverage volume of money market and savings deposits increased $19.0 millionduring the first three quarters 2006 compared to same period in 2005.

The cost of time certificates of deposit $100,000 andover increased 186 basis points during the first three quarters 2006 comparedto the 2005 period.  The cost of moneymarket and savings deposits increased 151 basis points while the cost ofcertificates of deposit under $100,000 increased 91 basis points.

The volume of other borrowings averaged $14.9 millionand $10.1 million during the first three quarters 2006 and 2005,respectively.  The cost of otherborrowings was 4.89% and 2.97% for the 2006 and 2005 periods, respectively,representing an increase of 192 basis points for the first three quarters 2006.

Repurchase Agreements averaged $29.8 million duringthe first three quarters 2006 with a cost of 5.37%.  We had no Repurchase Agreements during 2005.

Noninterest-bearing demand deposits averaged $114.2million during the first three quarters 2006 or $11.3 million less than duringthe same period in 2005.  Depositors haveredeployed their noninterest-bearing demand deposits into higher yield, yetaccessible, money market deposits as short-term interest rates have risen.

The net yield on interest earning assets (net interestmargin) was 5.22% and 5.60% during the first three quarters in 2006 and 2005,respectively, while the net interest spread was 4.20% and 4.85%,respectively.  Similar to the quarterly results,the net interest margin and net interest spread during the first three quarters2006 have declined from recent quarters due to (i) the securities leveragestrategy, (ii) a more rapid rise in the cost of fund than in the yield onearnings assets due to the flat yield curve, (iii) a change in the mix ofdeposits to higher costing types, and (iv) a smaller proportion of noninterestbearing deposits funding earning assets.

21

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Thefollowing table presents the components of net interest income for the threemonths ended September 30, 2006 and 2005.

**AverageBalance Sheet andAnalysis of Net Interest Income**

 
| ** **                                                                                     | ** ** | **Three Months ended**     | ** ** |
|------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                     | ** ** | **September 30, 2006**     | ** ** | **September 30, 2005** | ** ** |
| ** **                                                                                     | ** ** | **Average  Amount**                  | ** ** | **Interest  Income/  Expense** | ** ** | **Weighted  Average  Yield/  Rate** | ** ** | **Average  Amount** | ** ** | **Interest  Income/  Expense** | ** ** | **Weighted  Average  Yield/  Rate** | ** ** |
| ** **                                                                                     | ** ** | **(Dollars in thousands)** | ** ** |
| Assets:                                                                                        |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Federal funds  sold and securities purchased under agreements to resell                        |       | $                                    | 4,396      |   | $ | 58 |   | 5.23 | % | $ | 1,604 |   | $ | 14 |   | 3.46 | % |
| Due from  banks-interest-bearing                                                               |       | 3,216                                |       | 47 |   | 5.80 | % | 2,000 |   | 23 |   | 4.56 | % |
| Securities  available-for-sale                                                                 |       | 97,991                               |       | 1,384 |   | 5.60 | % | 53,050 |   | 494 |   | 3.72 | % |
| Securities  held-to-maturity                                                                   |       | 2,319                                |       | 24 |   | 4.11 | % | 2,954 |   | 29 |   | 3.93 | % |
| Loans receivable  (1) (2)                                                                      |       | 348,738                              |       | 7,735 |   | 8.80 | % | 315,735 |   | 6,194 |   | 7.78 | % |
| Total interest earning assets                                                                  |       | 456,660                              |       | 9,248 |   | 8.03 | % | 375,343 |   | 6,754 |   | 7.14 | % |
|                                                                                           |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest  earning assets:                                                                   |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks - demand                                                               |       | 13,300                               |       |   |   |   |   | 15,196 |   |   |   |   |   |
| Other assets                                                                                   |       | 22,679                               |       |   |   |   |   | 20,428 |   |   |   |   |   |
| Allowance for credit losses and net unrealized gain  on sales of securities available-for-sale |       | (6,303                               | )          |   |   |   |   | (5,395 | ) |   |   |   |   |
| Total assets                                                                                   |       | $                                    | 486,336    |   |   |   |   |   | $ | 405,572 |   |   |   |   |   |
|                                                                                           |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Liabilities and  shareholders’ equity:                                                    |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  deposits:                                                                    |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Demand                                                                                         |       | $                                    | 30,827     |   | $ | 63 |   | 0.81 | % | $ | 34,483 |   | $ | 46 |   | 0.53 | % |
| Money market and savings                                                                       |       | 117,774                              |       | 929 |   | 3.13 | % | 101,809 |   | 350 |   | 1.36 | % |
| Time certificates of deposit:                                                                  |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| $100,000 or more                                                                               |       | 86,044                               |       | 924 |   | 4.26 | % | 51,794 |   | 323 |   | 2.47 | % |
| Under $100,000                                                                                 |       | 23,665                               |       | 206 |   | 3.45 | % | 24,873 |   | 161 |   | 2.57 | % |
| Total time certificates of deposit                                                             |       | 109,709                              |       | 1,130 |   | 4.09 | % | 76,667 |   | 484 |   | 2.50 | % |
| Total interest-bearing deposits                                                                |       | 258,310                              |       | 2,122 |   | 3.26 | % | 212,959 |   | 880 |   | 1.64 | % |
| Other borrowings                                                                               |       | 12,267                               |       | 183 |   | 5.92 | % | 9,912 |   | 92 |   | 3.68 | % |
| Junior  subordinated debentures                                                                |       | 15,464                               |       | 396 |   | 10.24 | % | 15,464 |   | 396 |   | 10.24 | % |
| Federal funds  purchased and securities sold under agreements to repurchase                    |       | 43,250                               |       | 686 |   | 6.29 | % | — |   | — |   | — |   |
| Total interest-bearing liabilities                                                             |       | 329,291                              |       | 3,387 |   | 4.08 | % | 238,335 |   | 1,368 |   | 2.28 | % |
|                                                                                           |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  liabilities:                                                              |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing demand deposits                                                            |       | 114,790                              |       |   |   |   |   | 128,523 |   |   |   |   |   |
| Other liabilities                                                                              |       | 1,399                                |       |   |   |   |   | 1,363 |   |   |   |   |   |
| Shareholders’  equity                                                                     |       | 40,856                               |       |   |   |   |   | 37,351 |   |   |   |   |   |
| Total  liabilities and shareholders’ equity                                               |       | $                                    | 486,336    |   |   |   |   |   | $ | 405,572 |   |   |   |   |   |
|                                                                                           |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Net interest  income (spread)                                                                  |       |                                 |       | $ | 5,861 |   | 3.95 | % |   |   | $ | 5,386 |   | 4.86 | % |
|                                                                                           |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Net yield on  earning assets (2)                                                               |       |                                 |       |   |   | 5.09 | % |   |   |   |   | 5.69 | % |

----

 

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

(2)             Yieldsand amounts earned on loans receivable include loan fees of $440,000 and$421,000 for the three months ended September 30, 2006 and 2005, respectively.

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The following table presents the components of netinterest income for the nine months ended September 30, 2006 and 2005.

**AverageBalance Sheet andAnalysis of Net Interest Income**

 
| ** **                                                                                     | ** ** | **Nine Months ended**      | ** ** |
|------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                     | ** ** | **September 30, 2006**     | ** ** | **September 30, 2005** | ** ** |
| ** **                                                                                     | ** ** | **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                        |       | $                                    | 1,933      |   | $ | 76 |   | 5.26 | % | $ | 1,932 |   | $ | 43 |   | 2.98 | % |
| Due from  banks-interest-bearing                                                               |       | 2,776                                |       | 98 |   | 4.72 | % | 2,250 |   | 57 |   | 3.39 | % |
| Securities  available-for-sale                                                                 |       | 93,348                               |       | 3,638 |   | 5.21 | % | 44,446 |   | 1,174 |   | 3.52 | % |
| Securities  held-to-maturity                                                                   |       | 2,382                                |       | 74 |   | 4.16 | % | 3,186 |   | 94 |   | 3.93 | % |
| Loans receivable  (1) (2)                                                                      |       | 349,061                              |       | 22,326 |   | 8.55 | % | 308,986 |   | 17,312 |   | 7.49 | % |
| Total interest earning assets                                                                  |       | 449,500                              |       | 26,212 |   | 7.80 | % | 360,800 |   | 18,680 |   | 6.92 | % |
|                                                                                           |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest  earning assets:                                                                   |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Cash and due from banks - demand                                                               |       | 14,164                               |       |   |   |   |   | 16,880 |   |   |   |   |   |
| Other assets                                                                                   |       | 22,927                               |       |   |   |   |   | 20,628 |   |   |   |   |   |
| Allowance for credit losses and net unrealized gain  on sales of securities available-for-sale |       | (6,180                               | )          |   |   |   |   | (4,611 | ) |   |   |   |   |
| Total assets                                                                                   |       | $                                    | 480,411    |   |   |   |   |   | $ | 393,697 |   |   |   |   |   |
|                                                                                           |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Liabilities and  shareholders’ equity:                                                    |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  deposits:                                                                    |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Demand                                                                                         |       | $                                    | 31,964     |   | $ | 165 |   | 0.69 | % | $ | 32,471 |   | $ | 113 |   | 0.47 | % |
| Money market and savings                                                                       |       | 119,802                              |       | 2,310 |   | 2.58 | % | 100,814 |   | 804 |   | 1.07 | % |
| Time certificates of deposit:                                                                  |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| $100,000 or more                                                                               |       | 86,159                               |       | 2,683 |   | 4.16 | % | 45,885 |   | 790 |   | 2.30 | % |
| Under $100,000                                                                                 |       | 23,741                               |       | 578 |   | 3.26 | % | 25,914 |   | 455 |   | 2.35 | % |
| Total time certificates of deposit                                                             |       | 109,900                              |       | 3,261 |   | 3.97 | % | 71,799 |   | 1,245 |   | 2.32 | % |
| Total interest-bearing deposits                                                                |       | 261,666                              |       | 5,736 |   | 2.93 | % | 205,084 |   | 2,162 |   | 1.41 | % |
| Other borrowings                                                                               |       | 14,918                               |       | 546 |   | 4.89 | % | 10,132 |   | 225 |   | 2.97 | % |
| Junior  subordinated debentures                                                                |       | 15,464                               |       | 1,189 |   | 10.25 | % | 15,464 |   | 1,189 |   | 10.25 | % |
| Federal funds  purchased and securities sold under agreements to repurchase                    |       | 29,826                               |       | 1,198 |   | 5.37 | % | — |   | — |   | — |   |
| Total interest-bearing liabilities                                                             |       | 321,874                              |       | 8,669 |   | 3.60 | % | 230,680 |   | 3,576 |   | 2.07 | % |
|                                                                                           |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing  liabilities:                                                              |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest-bearing demand deposits                                                            |       | 114,183                              |       |   |   |   |   | 125,469 |   |   |   |   |   |
| Other liabilities                                                                              |       | 4,594                                |       |   |   |   |   | 1,404 |   |   |   |   |   |
| Shareholders’  equity                                                                     |       | 39,760                               |       |   |   |   |   | 36,144 |   |   |   |   |   |
| Total  liabilities and shareholders’ equity                                               |       | $                                    | 480,411    |   |   |   |   |   | $ | 393,697 |   |   |   |   |   |
|                                                                                           |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Net interest  income (spread)                                                                  |       |                                 |       | $ | 17,543 |   | 4.20 | % |   |   | $ | 15,104 |   | 4.85 | % |
|                                                                                           |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Net yield on earning assets (2)                                                                |       |                                 |       |   |   | 5.22 | % |   |   |   |   | 5.60 | % |
|                                                                                           |       |                                 |       |   |   |   |   |   |   |   |   |   |   |

----

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

(2)             Yieldsand amounts earned on loans receivable include loan fees of $1.4 million and$1.3 million for the nine months ended September 30, 2006 and 2005,respectively. 

 

 

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The following table sets forth, for the periodsindicated, the changes in interest earned and interest paid resulting fromchanges in volume and changes in rates. Average balances in all categories in each reported period were used inthe volume computations.  Average yieldsand rates in each reported period were used in rate computations.

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**Increase (Decrease) in InterestIncome/Expense Due to Change inAverage Volume and Average Rate (1)**
| ** **                                                                  | ** ** | **Three Months ended September 30,  2006 vs 2005** | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                                                                  | ** ** | **Incease (decrease) due to:**                                         | ** ** | **Net  Increase** | ** ** |
| ** **                                                                  | ** ** | **Volume**                                                                       | ** ** | **Rate** | ** ** | **(Decrease)** | ** ** |
| ** **                                                                  | ** ** | **(Dollars in thousands)**                                             | ** ** |
| Interest Income:                                                            |       |                                                                             |       |   |   |   |   |
| Federal funds  sold and securities purchased under agreement to resell      |       | $                                                                                | 24         |   | $ | 20 |   | $ | 44 |   |
| Interest-bearing  deposits with other financial institutions                |       | 14                                                                               |       | 10 |   | 24 |   |
| Securities  available-for-sale                                              |       | 422                                                                              |       | 468 |   | 890 |   |
| Securities  held-to-maturity                                                |       | (6                                                                               | )          | 1 |   | (5 | ) |
| Loans receivable  (2)                                                       |       | 647                                                                              |       | 894 |   | 1,541 |   |
| Total  interest-earning assets                                              |       | $                                                                                | 1,101      |   | $ | 1,393 |   | $ | 2,494 |   |
|                                                                        |       |                                                                             |       |   |   |   |   |
| Interest Expense:                                                           |       |                                                                             |       |   |   |   |   |
| Interest-bearing  deposits:                                                 |       |                                                                             |       |   |   |   |   |
| Demand                                                                      |       | $                                                                                | (5         | ) | $ | 22 |   | $ | 17 |   |
| Money market and  savings                                                   |       | 55                                                                               |       | 524 |   | 579 |   |
| Time  certificates of deposit:                                              |       |                                                                             |       |   |   |   |   |
| $100,000 or more                                                            |       | 214                                                                              |       | 387 |   | 601 |   |
| Under $100,000                                                              |       | (8                                                                               | )          | 53 |   | 45 |   |
| Total time  certificates of deposit                                         |       | 206                                                                              |       | 440 |   | 646 |   |
| Total interest-bearing  deposits                                            |       | 256                                                                              |       | 986 |   | 1,242 |   |
| Other borrowings                                                            |       | 22                                                                               |       | 69 |   | 91 |   |
| Junior subordinated  debentures                                             |       | —                                                                           |       | — |   | — |   |
| Federal funds purchased  and securities sold under agreements to repurchase |       | —                                                                           |       | 686 |   | 686 |   |
| Total  interest-bearing liabilities                                         |       | 278                                                                              |       | 1,741 |   | 2,019 |   |
|                                                                        |       |                                                                             |       |   |   |   |   |
| Net interest income                                                         |       | $                                                                                | 823        |   | $ | (348 | ) | $ | 475 |   |

 

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(1)             The change ininterest income or interest expense that is attributable to both changes inaverage balance, average rate and days in the quarter has been allocated to thechanges due to (i) average balance and (ii) average rate in proportion to therelationship of the absolute amounts of changes in each.

(2)             Tabledoes not include interest income that would have been earned on nonaccrualloans.

25

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**Increase(Decrease) in Interest Income/Expense Due to Change inAverage Volume and Average Rate (1)**

 
| ** **                                                                  | ** ** | **Nine Months ended September 30,  2006 vs 2005** | ** ** |
|-----------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                                                                  | ** ** | **Increase (decrease) due to:**                                  | ** ** | **Net  Increase** | ** ** |
| ** **                                                                  | ** ** | **Volume**                                                                      | ** ** | **Rate** | ** ** | **(Decrease)** | ** ** |
|                                                                        |       |                                                                            |       |   |   |   |   |
| Interest Income:                                                            |       |                                                                            |       |   |   |   |   |
| Federal funds sold and securities purchased under  agreement to resell      |       | $                                                                               | —     |   | $ | 33 |   | $ | 33 |   |
| Interest-bearing deposits with other financial  institutions                |       | 13                                                                              |       | 28 |   | 41 |   |
| Securities available-for-sale                                               |       | 1,288                                                                           |       | 1,176 |   | 2,464 |   |
| Securities held-to-maturity                                                 |       | (24                                                                             | )          | 4 |   | (20 | ) |
| Loans receivable (2)                                                        |       | 2,245                                                                           |       | 2,769 |   | 5,014 |   |
| Total interest-earning assets                                               |       | 3,522                                                                           |       | 4,010 |   | 7,532 |   |
|                                                                        |       |                                                                            |       |   |   |   |   |
| Interest  Expense:                                                          |       |                                                                            |       |   |   |   |   |
| Interest-bearing deposits:                                                  |       |                                                                            |       |   |   |   |   |
| Demand                                                                      |       | $                                                                               | (1         | ) | $ | 54 |   | $ | 52 |   |
| Money market and savings                                                    |       | 151                                                                             |       | 1,355 |   | 1,506 |   |
| Time certificates of deposit:                                               |       |                                                                            |       |   |   |   |   |
| $100,000 or more                                                            |       | 693                                                                             |       | 1,200 |   | 1,893 |   |
| Under $100,000                                                              |       | (38                                                                             | )          | 161 |   | 123 |   |
| Total time certificates of deposit                                          |       | 655                                                                             |       | 1,361 |   | 2,016 |   |
| Total  interest-bearing deposits                                            |       | 805                                                                             |       | 2,769 |   | 3,574 |   |
| Other borrowings                                                            |       | 106                                                                             |       | 215 |   | 321 |   |
| Junior  subordinated debentures                                             |       | —                                                                          |       | — |   | — |   |
| Federal funds purchased and securities sold under  agreements to repurchase |       | —                                                                          |       | 1,198 |   | 1,198 |   |
| Total interest-bearing liabilities                                          |       | 911                                                                             |       | 4,182 |   | 5,093 |   |
|                                                                        |       |                                                                            |       |   |   |   |   |
| Net interest income                                                         |       | $                                                                               | 2,613      |   | $ | (172 | ) | $ | 2,439 |   |

 

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

(2)             Tabledoes not include interest income that would have been earned on nonaccrualloans.

 

26

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PROVISION FORCREDIT LOSSES

We recorded provisions for credit losses of $72,000 for the thirdquarter 2006 and $144,000 for the nine months ended September 30, 2006,reflecting (i) the growth in loans receivable, (ii) an increase in unfundedloan commitments, and (iii) a change in portfolio credit migration, compared toa benefit for loan losses of $213,000 for the third quarter 2005 and $124,000for the nine months ended September 30, 2005. During the first three quartersof 2006, we charged off loans receivable of $22,000 and had no recoveries ofloans previously charged off. During the third quarter 2005, the Companyrecovered $1.2 million of loans charged off in a previous period.

OTHER OPERATINGINCOME

Other operating income increased to $828,000 during the third quarterof 2006 compared to a loss of $145,000 during the third quarter of 2005.  The 2006 period included a trading gain onnon-hedge derivatives of $550,000 compared to a $493,000 trading loss onnon-hedge derivates during the third quarter 2005.  As a result of recent technical accountinginterpretations, we restated our financial statements for the incorrectaccounting treatment related to an interest rate swap that was designated as afair value hedge against our junior subordinated debentures.  The restatement resulted in the changes infair value of the swap being recorded in current income.  Due to the undesired volatility created bythis treatment, we terminated our position in the swap during the third quarter2006 resulting in the trading gain.

Other operating income decreased to $669,000 during the nine monthsended September 30, 2006 from $1.1 million during the nine months endedSeptember 30, 2005 due to a $209,000 decrease in other noninterest income and a$152,000 greater trading loss on non-hedge derivatives.  While the change in fair value for the swapdiscussed above resulted in a gain during the third quarter, overall it resultedin a $267,000 loss for the nine months ended September 30, 2006.

OTHER OPERATINGEXPENSES

Other operating expenses decreased $197,000 for thethree months ended September 30, 2006 to $3.5 million. Significant varianceswithin operating expenses were: (i) salaries and related benefits expenseincreased $133,000 or 6.7% due to the adoption of SFAS 133R requiring stockoptions to be expensed, the addition of business development staff andincreased commission expense, (ii) legal services expense decreased $107,000 or80.5% primarily due to fewer problem assets and the decline in related legalactivity; and (iii) other noninterest expenses declined $144,000 due to thereversal of a loss contingency in the 2006 quarter recorded in the 2005 quarterrelated to a potential operating loss.

Other operating expenses increased to $11.1 millionfor the nine months ended September 30, 2006 compared to $10.8 million for thesame period of 2005.  Significantvariances within operating expenses were: (i) salaries and related benefitsexpense increased $729,000 or 12.8% due to the adoption of SFAS 133R requiringstock options to be expensed, the addition of business development staff andincreased commission; and (ii) legal services expense decreased $469,000 or79.6% primarily due to activity on the settlement of a dispute over collateralsecuring a loan and fewer problem assets.

***BALANCESHEET ANALYSIS***

INVESTMENTSECURITIES

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

** **

27

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** **

**EstimatedFair Values of and UnrealizedGains and Losses on Securities**

 
| ** **                                                                | ** ** | **September 30, 2006**     | ** ** |
|---------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                | ** ** | **Total**                            | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                                                                | ** ** | **amortized**                        | ** ** | **unrealized** | ** ** | **unrealized** | ** ** | **fair** | ** ** |
| ** **                                                                | ** ** | **cost**                             | ** ** | **gains** | ** ** | **loss** | ** ** | **value** | ** ** |
| ** **                                                                | ** ** | **(Dollars in thousands)** | ** ** |
| **Available-for-Sale:**                                                   | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| U.S. Treasury  securities                                                 |       | $                                    | 2,561      |   | $ | — |   | $ | 26 |   | $ | 2,527 |   |
| GNMA-issued/guaranteed  mortgage pass through certificates                |       | 78                                   |       | — |   | — |   | 78 |   |
| Other U.S.  Government and federal agency securities                      |       | 9,018                                |       | 2 |   | 53 |   | 8,966 |   |
| FHLMC/FNMA-issued  mortgage pass through certificates                     |       | 55,838                               |       | 139 |   | 600 |   | 55,377 |   |
| CMO’s and  REMIC’s issued by U.S. government-sponsored agencies |       | 6,460                                |       | 25 |   | 32 |   | 6,453 |   |
| Privately issued  corporate bonds, CMO and REMIC securities               |       | 29,990                               |       | 185 |   | 258 |   | 29,917 |   |
|                                                                      |       | $                                    | 103,945    |   | $ | 351 |   | $ | 969 |   | $ | 103,318 |   |
|                                                                      |       |                                 |       |   |   |   |   |   |   |
| FRB and other equity  stocks                                              |       | $                                    | 3,790      |   | $ | — |   | $ | — |   | $ | 3,790 |   |

 
| ** **                                            | ** ** | **September 30, 2006**     | ** ** |
|-------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                            | ** ** | **Total**                            | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                                            | ** ** | **amortized**                        | ** ** | **unrealized** | ** ** | **unrealized** | ** ** | **fair** | ** ** |
| ** **                                            | ** ** | **cost**                             | ** ** | **gains** | ** ** | **loss** | ** ** | **value** | ** ** |
| ** **                                            | ** ** | **(Dollars in thousands)** | ** ** |
| **Held-to-Maturity:**                                 | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| FHLMC/FNMA-issued  mortgage pass through certificates |       | $                                    | 2,160      |   | $ | — |   | $ | 82 |   | $ | 2,078 |   |
|                                                  |       | $                                    | 2,160      |   | $ | — |   | $ | 82 |   | $ | 2,078 |   |

 
| ** **                                                                | ** ** | **December 31, 2005**      | ** ** |
|---------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                | ** ** | **Total**                            | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                                                                | ** ** | **amortized**                        | ** ** | **unrealized** | ** ** | **unrealized** | ** ** | **fair** | ** ** |
| ** **                                                                | ** ** | **cost**                             | ** ** | **gains** | ** ** | **loss** | ** ** | **value** | ** ** |
| ** **                                                                | ** ** | **(Dollars in thousands)** | ** ** |
| **Available-For-Sale:**                                                   | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| U.S. Treasury  securities                                                 |       | $                                    | 599        |   | $ | — |   | $ | — |   | $ | 599 |   |
| GNMA-issued/guaranteed  mortgage pass through certificates                |       | 98                                   |       | 2 |   | — |   | 100 |   |
| Other U.S. government  and federal agency securities                      |       | 17,931                               |       | — |   | 152 |   | 17,779 |   |
| FHLMC/FNMA-issued  mortgage pass through certificates                     |       | 33,982                               |       | 47 |   | 366 |   | 33,663 |   |
| CMO’s and  REMIC’s issued by U.S. government-sponsored agencies |       | 2,528                                |       | 13 |   | — |   | 2,541 |   |
| Privately issued  corporate bonds, CMO and REMIC securities               |       | 17,290                               |       | 3 |   | 217 |   | 17,076 |   |
|                                                                      |       | $                                    | 72,428     |   | $ | 65 |   | $ | 735 |   | $ | 71,758 |   |
|                                                                      |       |                                 |       |   |   |   |   |   |   |
| FRB and other equity  stocks                                              |       | $                                    | 3,809      |   | $ | — |   | $ | — |   | $ | 3,809 |   |

 
| ** **                                            | ** ** | **December 31, 2005**      | ** ** |
|-------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                            | ** ** | **Total**                            | ** ** | **Gross** | ** ** | **Gross** | ** ** | **Estimated** | ** ** |
| ** **                                            | ** ** | **amortized**                        | ** ** | **unrealized** | ** ** | **unrealized** | ** ** | **fair** | ** ** |
| ** **                                            | ** ** | **cost**                             | ** ** | **gains** | ** ** | **loss** | ** ** | **value** | ** ** |
| ** **                                            | ** ** | **(Dollars in thousands)** | ** ** |
|                                                  |       |                                 |       |   |   |   |   |   |   |
| **Held-to-Maturity:**                                 | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| FHLMC/FNMA-issued  mortgage pass through certificates |       | $                                    | 2,612      |   | $ | — |   | $ | 40 |   | $ | 2,572 |   |
|                                                  |       |                                 |       |   |   |   |   |   |   |
|                                                  |       | $                                    | 2,612      |   | $ | — |   | $ | 40 |   | $ | 2,572 |   |

 

 

28

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As of September 30, 2006, the Company did not holdsecurities of any issuer, other than U.S. government-chartered agencies, theaggregate book value of which exceeded 10% of the Company’s shareholders’equity.  At September 30, 2006 andDecember 31, 2005 there were no securities deemed by management to beother-than-temporarily impaired.

LOAN PORTFOLIO

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

**LoanPortfolio Composition**
| ** **                                                            | ** ** | **September 30,**               | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------|------------|
| ** **                                                            | ** ** | **2006**                             | ** ** | **2005**              | ** ** |
| ** **                                                            | ** ** | **Amount**                           | ** ** | **Percent**           | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **                                                            | ** ** | **(Dollars in thousands)** | ** ** |
| Commercial loans  - secured and unsecured                             |       | $                                    | 100,757    |                  | 28         | % | $ | 89,474 |   | 26 | % |
| Real estate  loans:                                                   |       |                                 |       |                  |       |   |   |   |   |
| Secured by commercial real properties                                 |       | 135,577                              |       | 38                    | %          | 121,641 |   | 36 | % |
| Secured by one to four family residential properties                  |       | 10,170                               |       | 2                     | %          | 10,498 |   | 3 | % |
| Secured by multifamily residential properties                         |       | 16,490                               |       | 5                     | %          | 18,663 |   | 6 | % |
| Total real estate loans                                               |       | 162,237                              |       | 45                    | %          | 150,802 |   | 45 | % |
| Construction and  land development                                    |       | 88,407                               |       | 25                    | %          | 92,077 |   | 27 | % |
| Consumer  installment, home equity and unsecured loans to individuals |       | 7,434                                |       | 2                     | %          | 7,239 |   | 2 | % |
| Total loans outstanding                                               |       | 358,835                              |       | 100                   | %          | 339,592 |   | 100 | % |
|                                                                  |       |                                 |       |                  |       |   |   |   |   |
| Deferred net  loan origination fees                                   |       | (615                                 | )          |                  |       | (1,034 | ) |   |   |
| Loans receivable, net                                                 |       | $                                    | 358,220    |                  |       |   | $ | 338,558 |   |   |   |

 

Totalloans outstanding increased by $19.7 million to $358.2 million at September 30,2006 compared to $338.6 million at December 31, 2005 due primarily to increasedfunding of commercial real estate loans and secured and unsecured commercialloans.  We have increased funding ofintermediate-term fixed rate commercial real estate loans as part of ourinterest rate risk management strategy. The balance of construction loans declined at September 30, 2006 fromyear end 2005 due to a greater volume of payoffs of outstanding loans thanadditional funding of loan commitments and newly generated loans.  Commitments to fund loans at September 30,2006 totaled $55.0 million compared to $120.8 million at December 31, 2005.

29

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NONPERFORMING ASSETS

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

**NonperformingAssets**

|                                                                                                                             | ** ** | **September 30,**               | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                  | ** ** | **2006**                             | ** ** | **2005**              | ** ** |
| ** **                                                                                                                  | ** ** | **(Dollars in thousands)** | ** ** |
|                                                                                                                        |       |                                 |       |                  |       |
| Nonaccrual loans                                                                                                            |       | $                                    | 338        |                  | $          | 319 |   |
| Troubled debt  restructurings                                                                                               |       | —                               |       | —                |       |
| Loans  contractually past due ninety or more days with respect to either principal  or interest and still accruing interest |       | —                               |       | —                |       |
| Nonperforming  loans                                                                                                        |       | 338                                  |       | 319                   |       |
| Other real  estate owned                                                                                                    |       | —                               |       | 1,056                 |       |
| Other nonperforming  assets                                                                                                 |       | —                               |       | —                |       |
| Total  nonperforming assets                                                                                                 |       | $                                    | 338        |                  | $          | 1,375 |   |
|                                                                                                                        |       |                                 |       |                  |       |
| Allowance for  credit losses as a percent of nonaccrual loans                                                               |       | 1379.0                               | %          | 1400.6                | %          |
| Allowance for  credit losses as a percent of nonperforming loans                                                            |       | 1379.0                               | %          | 1400.6                | %          |
| Total nonperforming  assets as a percent of loans receivable                                                                |       | 0.1                                  | %          | 0.4                   | %          |
| Total nonperforming  assets as a percent of total shareholders’ equity                                                 |       | 0.8                                  | %          | 3.6                   | %          |

 

ALLOWANCE FOR CREDIT LOSSES

The adequacy of the allowance for credit losses is determined throughperiodic analysis of the loan portfolio. This analysis includes a systematic and detailed review of theclassification and categorization of problem loans; an assessment of theoverall quality and collectibility of the portfolio; and consideration of theloan loss experience, trends in problem loans, concentrations of credit risk,as well as current economic conditions (particularly Southern California).  Management performs a periodic risk andcredit analysis, the results of which are reported to the Board of Directors.

There were no recoveries of loans previously charged off during thethird quarter of 2006 compared to $1.2 million during the third quarter of2005.  Pursuant to our evaluation of theallowance for credit losses at September 30, 2006, we recorded a provision forcredit losses of $72,000 for the third quarter 2006 compared to a benefit forloan losses of $213,000 in the 2005 quarter.

We charged off $22,000 of loans during the nine months ended September30, 2006 compared to $6,000 of loans charged off during the same period of2005.   There were no recoveries of loanspreviously charged off during the nine months ended 

 

30

----

 

September 30, 2006compared to $1.2 million during the same period of 2005.  We recorded a provision for credit losses of$144,000 for the nine months September 30, 2006 compared to a benefit for loanslosses of $124,000 in the 2005 period.

The followingtable reflects the balances and activity in the allowance for loan losses forthe dates shown:

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

|                                                                           | ** ** | **Nine Months ended September 30,** | ** ** |
|---------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
| ** **                                                                | ** ** | **(Dollars in thousands)**                    | ** ** |
|                                                                      |       |                                                    |       |   |   |
| Balance,  beginning of period                                             |       | $                                                       | 4,468      |   | $ | 3,511 |   |
| Total loans charged-off                                                   |       | 22                                                      |       | 6 |   |
| Total recoveries of loans previously charged off                          |       | —                                                  |       | 1,216 |   |
| Net charge-offs                                                           |       | 22                                                      |       | (1,210 | ) |
| Provision (benefit) for credit losses                                     |       | 144                                                     |       | (124 | ) |
| Transfer (to) from reserve for contingent losses on  unfunded commitments |       | 71                                                      |       | (71 | ) |
| Balance, end of  period                                                   |       | $                                                       | 4,661      |   | $ | 4,526 |   |

 

Creditquality is affected by many factors beyond the control of the Company,including local and national economies, and facts may exist which are not knownto the Company that adversely affect the likelihood of repayment of variousloans in the loan portfolio and realization of collateral upon a default.Accordingly, no assurance can be given that the Company will not sustain loanlosses materially in excess of the allowance for credit losses. In addition,the Office of the Comptroller of the 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 $379.4 million and $363.2 million at September 30,2006 and December 31, 2005, respectively.  Noninterest-bearing demand deposits werenearly flat at $115.7 million at September 30, 2006 compared to $115.9 millionat December 31, 2005. Money market deposits and savings deposits were $109.2million and $24.4 million, respectively, at September 30, 2006 compared to$76.3 million and $28.2 million, respectively, at December 31, 2005.  Interest-bearing demand deposits, which forthe most part are limited to individuals, decreased to $27.7 million atSeptember 30, 2006 from $36.0 million at December 31, 2005. Time certificatesof deposit (“TCDs”) decreased to $102.2 million at September 30, 2006 from$106.7 million at December 31, 2005. There were $50.0 million in brokered TCDs at September 30, 2006 comparedto $37.5 million at December 31, 2005. The Brokered CDs are typically 1-year terms and have been swapped toadjustable rate.  We utilize the brokeredCDs as part of our interest rate risk management and liquidity managementstrategies.

 

31

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Additionally,although we have priced our retail certificates of deposit to encourage runoffduring the past several years, in the rising rate environment experiencedduring the past nine quarters, we have elected to only moderately increaserates on our immediately repriceable base of deposits – interest-bearing demanddeposits, and savings and money market deposits – and price new timecertificates of deposit to generate growth.

In asustained rising interest rate environment, increases in deposit interest rateswill be required to prevent net deposit withdrawals.  Additionally, in order to generate newdeposit growth, the Company has paid significantly higher rates than that paidon existing deposits.  Also, we have beenmaking more frequent exceptions to our posted rates in order to generate andretain deposits.

SECURITIES SOLDUNDER AGREEMENTS TO REPURCHASE

RepurchaseAgreements totaled $45.0 million at September 30, 2006.  We entered into the Repurchase Agreements tofurther our liquidity and interest rate sensitivity objectives.  The Repurchase Agreements are adjustable rateand contain embedded interest rate floors that will result in an exponentialdecline in cost in the event of a sustained decline in interest rates.  The embedded interest rate floors are clearlyand closely related to the economic characteristics and risks of the underlyingRepurchase Agreements and accordingly are not separated and accounted for asderivative instruments.   We had norepurchase agreements at December 31, 2005.

JUNIOR SUBORDINATED DEBENTURES

Therecorded balance of Junior Subordinated Debentures was $15.5 million at June30, 2006 and December 31, 2005.  TheJunior Subordinated Debentures have a 10.25% fixed rate and are dueJuly 25, 2031. The interest is deferrable, at the Company’s option, for aperiod up to ten consecutive semi-annual payments, but in any event not beyondJune 25, 2031.  The debentures areredeemable, in whole or in part, at the Company’s option on or after five yearsfrom issuance at declining premiums to maturity.

OTHER BORROWINGS

Therewere $7.6 million of other borrowings, consisting of overnight advances fromthe Federal Home Loan Bank, at September 30, 2006 compared to $28.3 million atDecember 31, 2005.   The decline inother borrowings reflected repayment with alternative wholesale fundingsources, including brokered time certificates of deposit and RepurchaseAgreements.

32

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SHAREHOLDERS’ EQUITY

Shareholders’ equity increased from $38.2 million at December 31, 2005to $42.8 million at September 30, 2006 due to the retained earnings for thenine months ended September 30, 2006 in addition to an increase in market valueof derivative financial instruments designated as cash flow hedges andsecurities available-for-sale.

***CAPITALADEQUACY REQUIREMENTS***

AtSeptember 30, 2006, National Mercantile and the Banks were in compliance withall applicable regulatory capital requirements and the Banks were “wellcapitalized” under the Prompt Corrective Action rules of the OCC.  The following table sets forth the regulatorycapital standards for well-capitalized institutions, and the capital ratios forNational Mercantile and the Banks, as of September 30, 2006 and December 31,2005.

**RegulatoryCapital Informationof the National Mercantile Bancorp and Banks**
| ** **                        | ** ** | **Minimum**          | ** ** | ** **      | ** ** | ** **             | ** ** | ** **            | ** ** |
|-----------------------------------|------------|----------------------|------------|-----------------|------------|------------------------|------------|-----------------------|------------|
| ** **                        | ** ** | **For Capital** | ** ** | **Well**        | ** ** | ** **             | ** ** | ** **            | ** ** |
| ** **                        | ** ** | **Adequacy**         | ** ** | **Capitalized** | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **                        | ** ** | **Purposes**         | ** ** | **Standards**   | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| ** **                        | ** ** | ** **           | ** ** | ** **      | ** ** | ** **             | ** ** | ** **            | ** ** |
| **National  Mercantile Bancorp:** |       |                 |       |            |       |                   |       |                  |       |
| Tier 1 leverage                   |       | 4.00                 | %          | N/A             |       | 11.15                  | %          | 10.74                 | %          |
| Tier 1  risk-based capital        |       | 4.00                 | %          | N/A             |       | 12.56                  | %          | 11.98                 | %          |
| Total risk-based  capital         |       | 8.00                 | %          | N/A             |       | 13.94                  | %          | 13.72                 | %          |
|                              |       |                 |       |            |       |                   |       |                  |       |
| **Mercantile  National Bank:**    |       |                 |       |            |       |                   |       |                  |       |
| Tier 1 leverage                   |       | 4.00                 | %          | 5.00            | %          | 9.37                   | %          | 10.49                 | %          |
| Tier 1  risk-based capital        |       | 4.00                 | %          | 6.00            | %          | 11.83                  | %          | 13.59                 | %          |
| Total risk-based  capital         |       | 8.00                 | %          | 10.00           | %          | 13.07                  | %          | 14.84                 | %          |
|                              |       |                 |       |            |       |                   |       |                  |       |
| **South  Bay Bank, NA:**          |       |                 |       |            |       |                   |       |                  |       |
| Tier 1 leverage                   |       | 4.00                 | %          | 5.00            | %          | 10.39                  | %          | 9.04                  | %          |
| Tier 1  risk-based capital        |       | 4.00                 | %          | 6.00            | %          | 11.20                  | %          | 9.00                  | %          |
| Total risk-based  capital         |       | 8.00                 | %          | 10.00           | %          | 12.44                  | %          | 10.22                 | %          |

 

***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.  TheConsolidated Statement of Cash Flows reflects the Company’s sources and uses ofcash flows from operating, investing and financing activities.

The Company’s cash and due from banks - demand was$10.7 million on September 30, 2006 compared to $13.5 million on December 31,2005.  Due from banks-interest-bearingwas $2.0 million at September 30, 2006 and December 31, 2005.  

33

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There were no Federal funds sold at September 30, 2006compared to $685,000 at December 31, 2005. Mercantile had $12.5 million and South Bay had $10.0 million in Federalfunds lines with correspondent banks as of September 30, 2006.

NationalMercantile is a legal entity separate and distinct from the Banks and,therefore, it must provide for its own liquidity.  National Mercantile’s principal sources offunds are proceeds from the sales of securities and dividends or capitaldistributions from the Banks.  Inaddition to funding its own operating expenses, National Mercantile isresponsible for the payment of the interest on the outstanding JuniorSubordinated Debentures.  The semiannualinterest payments on the Junior Subordinated Debentures are deferrable atNational Mercantile’s option, for a period up to ten consecutive semiannualpayments, but in any event not beyond June 25, 2031.   National Mercantile has not deferred anyinterest payments.

NationalMercantile’s cash and due from banks was $237,000 on September 30, 2006compared to $137,000 at December 31, 2005.  Due from banks-interest bearing was $1.0 million at December 31, 2005and none at September 30, 2006.

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

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

National banks that are not in compliance withregulatory capital requirements generally are not permitted to paydividends.  The OCC also can prohibit anational bank from engaging in an unsafe or unsound practice in itsbusiness.  Depending on the bank’sfinancial condition, payment of dividends could be deemed to constitute anunsafe or unsound practice.     Exceptunder certain circumstances, and with prior regulatory approval, a bank may notpay a dividend if, after so doing, it would be undercapitalized.  A bank’s ability to pay dividends in thefuture is, and could be, further influenced by regulatory policies oragreements and by capital guidelines.

Mercantile has a substantial accumulated deficit anddoes not anticipate having positive cumulative retained earnings for theforeseeable future.  South Bay hadcumulative retained earnings of $5.6 million as of September 30, 2006.  Mercantile and South Bay may from time totime be permitted to make capital distributions to National Mercantile with theconsent of the OCC.  It is likely thatsuch consent could not be obtained unless the distributing bank remained “wellcapitalized” following such distribution.

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***INTERESTRATE RISK MANAGEMENT***

We manage interest rate sensitivity by matching the repricingopportunities on our earning assets to those on our funding liabilities.  Various strategies are used to manage therepricing characteristics of assets and liabilities to ensure that exposure tointerest rate fluctuations is limited within guidelines of acceptable levels ofrisk-taking.  Hedging strategies,including the terms and pricing of loans and deposits, the use of derivativefinancial instruments (see Note 10 of the Notes to the Consolidated FinancialStatements) and managing the deployment of securities are used to reducemismatches in interest rate repricing opportunities of portfolio assets andtheir funding sources.  Interest raterisk is measured using financial modeling techniques, including stress tests,to measure the impact of changes in interest rates on future earnings.  These static measurements do not reflect theresults of any projected activity and are best used as early indicators ofpotential interest rate exposures.

Through various interest rate risk management strategies, we believethat our balance sheet is nearly neutral and that changes in interest rateswill have a limited impact upon our net interest income. These strategies haveincluded securities leverage in which purchases of intermediate term investmentsecurities which were funded by short-term or adjustable wholesale liabilities. Some of the wholesale liabilities are adjustable Repurchase Agreementswith embedded floors that, in a declining interest rate environment, willdecline at an exponential rate to the decline in the underlying index.Additionally, the Company has entered into interest rate swap agreements andhas purchased interest rate floors at various strike prices and terms that havethe effect of further reducing its exposure to declining interest rates.

Since interest rates began increasing in June 2004, the Company’sdeposit funding costs have lagged the increase in earning asset yields.  This lag in funding costs could narrow futurenet interest margins in the event that rates paid on deposits begin rising morerapidly due to increased funding needs or competitive pressures

# **FACTORS WHICH MAY AFFECT FUTUREOPERATING RESULTS**

The Company’s results ofoperations and financial condition are affected by many factors, including thefollowing:

**Risk fromchanges in interest rates.**

The success of theCompany’s business depends, to a large extent, on its net interest income.  Changes in market interest rates can affectnet interest income by affecting the spread between interest-earning assets andinterest-bearing liabilities.  This maybe due to the different maturities of interest-earning assets andinterest-bearing liabilities, as well as an increase in the general level of interestrates.  Changes in market interest ratesalso affect, among other things:

·                  The Company’sability to originate loans;

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·                  The abilityof borrowers to make payments on their loans;

·                  The value ofinterest-earning assets and ability to realize gains from the sale of theseassets;

·                  The averagelife of interest-earning assets;

·                  The abilityto generate deposits instead of other available funding alternatives; and

·                  The abilityto access the wholesale funding market.

        Interestrates are highly sensitive to many factors, including governmental monetarypolicies, domestic and international economic and political conditions andother factors beyond the Company’s control.

**Risk frompossible declines in the quality of the Company’s assets.**

        TheCompany’s financial condition depends significantly on the quality of itsassets.  While its has developed andimplemented underwriting policies and procedures to guide management in themaking of loans, compliance with these policies and procedures in making loansdoes not guarantee repayment of the loans. If the level of non-performing assets rises, the results of operationsand financial condition will be affected. A borrower’s ability to pay its loan in accordance with its terms can beadversely affected by a number of factors, such as a decrease in the borrower’srevenues and cash flows due to adverse changes in economic conditions or adecline in the demand for the borrower’s products and/or services.

**Allowancesfor credit losses may be inadequate.**

        Allowances for credit losses areestablished against each segment of the loan portfolio.  At September 30, 2006, the allowance forcredit losses equaled 1.30% of loans receivable and 1379.0% of nonperformingloans.  Although management believes thatit has established adequate allowances for credit losses as of September 30,2006, the credit quality of the Company’s assets is affected by many factorsbeyond its control, including local and national economic conditions, and thepossible existence of facts which are not currently known which adverselyaffect the likelihood of repayment of various loans in the loan portfolio andrealization of the collateral upon a default. Accordingly, there is no assurance that the Company will not sustainloan losses materially in excess of the allowance for credit losses.  In addition, the Office of the Comptroller ofthe Currency, as an integral part of its examination process, periodicallyreviews the allowance for credit losses and could require additional provisionsfor credit losses.  Material future additionsto the allowance for credit losses may also be necessary due to increases inthe size and changes in the composition of the loan portfolio.  Increases in the provisions for credit losseswould adversely affect the Company’s results of operations.

**Economicconditions may worsen.**

         The Company’s business is stronglyinfluenced by economic conditions in its market area (principally, the greaterLos Angeles metropolitan area) as well as regional and national economicconditions and in its niche markets, including the 

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entertainment industryin Southern California.  Should theeconomic condition in these areas worsen, the financial condition of itsborrowers could weaken, which could lead to higher levels of loan defaults or adecline in the value of collateral for its loans.  In addition, an unfavorable economy couldreduce the demand for its loans and other products and services.

**Because asignificant amount of the loans are made to borrowers in California, theCompany’s operations could suffer as a result of local recession or natural disastersin California.**

      At September 30, 2006, alarge majority of the loans outstanding were collateralized by real propertieslocated in California.  Because of thisconcentration in California, the Company’s financial position and results ofoperations have been and are expected to continue to be influenced by generaltrends in the California economy and its real estate market.  Real estate market declines may adverselyaffect the values of the properties collateralizing loans.  If the principal balances of the loans,together with any primary financing on the mortgaged properties, equal orexceed the value of the mortgaged properties, the Company could incur higherlosses on sales of properties collateralizing foreclosed loans.  In addition, California historically has beenvulnerable to certain natural disaster risks, such as earthquakes anderosion-caused mudslides, which are not typically covered by the standardhazard insurance policies maintained by borrowers.  Uninsured disasters may adversely impact theability to recover losses on properties affected by such disasters andadversely impact the Company’s results of operations.

**TheCompany’s business is very competitive.**

       There isintense competition in Southern California and elsewhere in the United Statesfor banking customers.  The Companyexperiences competition for deposits from many sources, including creditunions, insurance companies and money market and other mutual funds, as well asother commercial banks and savings institutions.  The Company competes for loans and depositsprimarily with other commercial banks, mortgage companies, commercial financecompanies and savings institutions.  Inrecent years out-of-state financial institutions have entered the Californiamarket, which has also increased competition. Many of the competitors have greater financial strength, marketingcapability and name recognition, and operate on a statewide or nationwidebasis.  In addition, recent developmentsin technology and mass marketing have permitted larger companies to marketloans more aggressively to small business customers.  Such advantages may give the competitorsopportunities to realize greater efficiencies and economies of scale than theCompany can.  There is no assurance thatthe Company will be able to compete effectively against its competition.

**TheCompany’s business is heavily regulated.**

       Both National Mercantile as a bankholding company, and Mercantile and South Bay, as national banks, are subjectto significant governmental supervision and regulation, which is intendedprimarily for the protection of depositors. Statutes and 

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regulationsaffecting the Company may be changed at any time, and the interpretation ofthese statutes and regulations by examining authorities also may change.  There is no assurance that future changes inapplicable statutes and regulations or in their interpretation will notadversely affect the Company’s business.

**Goodwillis evaluated annually and any impairment must be recorded as a charge to earnings**.

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

The Company hasgoodwill of $3.2 million in connection with the South Bay acquisition inDecember 2001.  During the fourth quarterof 2005, the required impairment tests of goodwill were completed.  The tests determined that goodwill was notconsidered impaired.  No assurance can begiven that goodwill will not become impaired in the future.

CAUTIONARY NOTE REGARDING FORWARD-LOOKINGSTATEMENTS

This report containsforward-looking statements about the Company. Forward-looking statements consist of description of plans or objectivesfor future operations, products or services, forecasts of revenues, earnings orother measures of economic performance and assumptions underlying or relating toany of the foregoing.  Becauseforward-looking statements discuss future events or conditions and nothistorical facts, they often include words such as “anticipate,” “believe,” “estimate,”“expect,” “intend,” “plan,” “project,” “target,” “can,” “could,” “may,” “should”or similar expressions.   Do not relyunduly on forward-looking statements. They give the Company’s expectations about the future and are notguarantees or predictions of futures events, conditions or results.  Forward-looking statements speak only as ofthe date they are made, and the Company does not undertake to update them toreflect changes that occur after that date.

Many factors, most beyondthe Company’s control, could cause actual results to differ significantly fromthe Company’s expectations   Theseinclude, among other things, changes in interest rates which reduce interestmargins, impact funding sources or diminish loan demand; increased competitivepressures; adverse changes in national and local economic conditions, and in realestate markets in California; changes in fiscal policy, monetary policy;legislative or regulatory environments, requirements or changes which adverselyaffect the Company; and declines in the credit quality of the Company’s loanportfolio.  See “Factors Which May AffectFuture Operating Results.”

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

The Companymaintains disclosure controls and procedures (as defined in Exchange Act Rule13a-15(e)) that are designed to assure that information required to bedisclosed in its Exchange Act reports is recorded, processed, summarized andreported within the time periods specified in the Securities and ExchangeCommission’s rules and forms, and that such information is accumulated andcommunicated to management, including the Chief Executive Officer and ChiefFinancial Officer, as appropriate, to allow timely decisions regarding requireddisclosures.

In designing andevaluating the disclosure controls and procedures, management recognizes thatany controls and procedures, no matter how well designed and operated, canprovide reasonable assurance only of achieving the desired control objectives,and management necessarily is required to apply its judgment in weighting thecosts and benefits of possible new or different controls and procedures.  Limitations are inherent in all controlsysytems, so no evaluation of controls can provide absolute assurance that allcontrol issues and any fraud within the company have been detected.

As required byExchange Act Rule 13a-15(b), as of the end of the period covered by this reportthe Company, under  the supervision andwith the participation of our Chief Executive Officer and Chief FinancialOfficer, evaluated the effectiveness of the Company’s disclosure controls andprocedures.  Based on this evaluation,our Chief Executive Officer and Chief financial Officer concluded that theCompany’s disclosure controls and procedures were effective as of that date.

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 reasonably likely to materially affect, the Company’s internal controlover financial reporting.

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**PARTII—OTHER INFORMATION**

***Item 1.       LEGAL PROCEEDINGS***

None.

***Item 2.       UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS***

None.

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

None.

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

None.

***Item 5.       OTHER INFORMATION***

None.

***Item 6.       EXHIBITS***

31.1 Certification of ScottA. Montgomery on disclosure controls

31.2 Certification of DavidR. Brown on disclosure controls

32.1 Certification of ScottA. Montgomery pursuant to section 906 of the Sarbanes-Oxley Act of 2002

32.2 Certification of DavidR. Brown pursuant to section 906 of the Sarbanes-Oxley Act of 2002

 

**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.
|            |              |   | **NATIONAL MERCANTILE  BANCORP**                      |                |
|------------|-------------------|--------|-------------------------------------------------------|---------------------|
|       |              |   | (Registrant)                                          |                |
|       |              |   |                                                  |                |   |
| DATE:      | November 14, 2006 |   | /s/                                                   | SCOTT A. MONTGOMERY |   |
| ** ** |              |   | **Scott  A. Montgomery**                              |                |
|       |              |   | Chief Executive  Officer                              |                |
|       |              |   |                                                  |                |   |
| DATE:      | November 14, 2006 |   | /s/                                                   | DAVID R. BROWN      |   |
| ** ** |              |   | **David  R. Brown**                                   |                |
|       |              |   | Principal  Financial and Principal Accounting Officer |                |

 

 

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