FORM
10-K


















-------------------------SONOMA
      VALLEY BANCORP(Name
      of registrant at as specific in its charter)CALIFORNIA
            
            68-0454068(State
      of incorporation)
            
            (I.R.S.
      Employer Identification No.)202
      West Napa StreetSonoma,
      California 95476(707)
      935-3200(Address,
      including zip code, and telephone number,including
      area code, of principal executive offices)------------------------




Securities
to be registered under section 12(b) of the Exchange Act: None


Securities
to be registered under section 12(g) of the Exchange Act:




Name
      of each exchangeTitle
      of each class
            on
      which registeredCommon
      Stock, No Par Value
            None







































As of
June 30, 2008, the aggregate market value of the registrant’s common stock held
by non-affiliates of the registrant was $41,567,872 based on the closing sale
price as reported on the Over the Counter Bulletin Board (“OTC Bulletin
Board”).





Indicate
the number of shares outstanding of each of the issuer’s classes of common
stock, as of the latest practicable date.





Class                                                                Outstanding at March 9,
2009


Common Stock, no par value per
share                                           2,313,821




DOCUMENTS
INCORPORATE BY REFERENCE





The
information required by Items 10,11,12,13 and 14 of Part III are incorporated by
reference to the registrant’s proxy statement, which will be filed within 120
days of the registrant’s year end.


2


With
the exception of historical facts stated herein, the matters discussed in this
Form 10-K are “forward looking” statements that involve risks and uncertainties
that could cause actual results to differ materially from projected results.
Such “forward looking” statements include, but are not necessarily limited to
statements regarding anticipated levels of future revenues and earnings from the
operation of Sonoma Valley Bancorp's (“the Company”) wholly owned subsidiary,
Sonoma Valley Bank (“the Bank”), projected costs and expenses related to
operations of the bank’s liquidity, capital resources, and the availability of
future equity capital on commercially reasonable terms. Factors that could cause
actual results to differ materially include, in addition to the other factors
identified in this Form 10-K, the following:
 
 (i)
              increased
      competition from other banks, savings and loan associations, thrift and
      loan associations, finance companies, credit unions, offerors of money
      market funds, and other financial
institutions;
 
 (ii)
              the
      risks and uncertainties relating to general economic and political
      conditions, both domestically and internationally, including, but not
      limited to, inflation, or natural disasters affecting the primary service
      area of the Bank or its major
industries;
 
 (iii)
              Changing
      business, banking, or regulatory conditions or policies, or new
      legislation, affecting the Bank’s activities at either the state or
      federal level, including the Emergency Economic Stabilization Act of 2008
      and related programs such as the U.S. government’s Troubled Assets Relief
      Program and any new legislation adopted by Congress and the administration
      of President Barack Obama, that could lead to changes in the competitive
      balance among financial institutions, restrictions on bank activities,
      changes in costs, including deposit insurance premiums, for particular
      financial institutions or financial institutions generally, declines in
      consumer confidence in depository institutions generally or certain
      financial institutions in particular or changes in the secondary market
      for bank loan and other products;
 
 Readers of this Form 10-K are cautioned
not to put undue reliance on “forward looking” statements which, by their
nature, are uncertain as reliable indicators of future
performance.  Sonoma Valley Bancorp disclaims any obligation to
publicly update these “forward looking” statements, whether as a result of new
information, future events, or otherwise.


3


PART I
 ITEM
1.                                BUSINESS
 
 General
 
 Sonoma
Valley Bancorp ("Company") was incorporated under California law on March 9,
2000 at the direction of Sonoma Valley Bank for the purpose of forming a
single-bank holding company structure pursuant to a plan of
reorganization.  The reorganization became effective November 1, 2000,
after obtaining all required regulatory approvals and permits, shares of the
Company's common stock were issued to shareholders of Sonoma Valley Bank in
exchange for their Sonoma Valley Bank stock.  Previously, Sonoma
Valley Bank filed its periodic reports and current reports under the Securities
Exchange Act of 1934 with the Federal Deposit Insurance Corporation
(“FDIC”).  Following the reorganization, periodic and current reports
are now filed with the Securities and Exchange Commission (“SEC”).
  The
business operations of the Company continue to be conducted through its
wholly-owned subsidiary, Sonoma Valley Bank ("Bank"), which began commercial
lending operations on June 3, 1988. In addition to its main branch located in
Sonoma, California, the Bank also operates two additional branch offices, one
branch office is located in Glen Ellen, California.  In March 2004,
the Bank opened another branch office, Banco de Sonoma, located in Boyes Hot
Springs, California.  The following discussion, although presented on
a consolidated basis, analyzes the financial condition and results of operations
of the Bank for the twelve month period ended December 31, 2008.
  Primary
Services
  The
Bank emphasizes the banking needs of small to medium-sized commercial
businesses, professionals and upper middle to high income individuals and
families in its primary service area of Sonoma, California and the immediate
surrounding area.  In recognition of CRA compliance, the Company
offers products to accommodate special needs of individuals regardless of their
economic status and more recently the Company has focused on the needs of the
Latino community.
  The
Bank offers depository and lending services keyed to the needs of its business
and professional clientele.  These services include a variety of
demand deposit, savings and time deposit account alternatives, all insured by
the FDIC up to its applicable limits.  Special merchant and business
services, such as coin, night depository, courier, on line cash management and
merchant teller services are available.  The Bank offers Internet
Banking for both commercial and consumer customers, bank by mail service,
drive-up ATM service, extended hours including Saturday banking, drive-up
windows and telephone voice response.  The Bank's lending activities
are directed primarily towards granting short and medium-term commercial loans,
augmented by customized lines of credit, for such purposes as operating capital,
business and professional start-ups, inventory, equipment, accounts receivable,
credit cards, and interim construction financing, personal loans and loans
secured by residential real estate.
  With
the opening of our third branch office, Banco de Sonoma, in March 2004, the Bank
is offering additional services to the Latino community in our market
place.  The Banco de Sonoma Office is predominantly staffed by
bilingual officers, customer service employees and tellers.  The Bank
offers special money transfer services to facilitate the transfer of funds to
Mexico.
  4
 The
business of the Bank is not seasonal.  The Bank intends to continue
with the same basic commercial banking activities with which it has operated
since beginning operations June 3, 1988.  Retail deposit gathering
activities at the branches comprise the bulk of sources for
lending.  The Bank has approved borrowing levels at the Federal Home
Loan Bank for temporary funding needs.
  Competition
  In
general, the banking business in California and in the market areas, which the
Bank serves, is highly competitive with respect to both loans and deposits, and
is dominated by a relatively small number of major banks, which have many
offices operating over a wide geographic area.  The Bank competes for
loans and deposits with these and other regional banks, including several which
are much larger than the Bank, as well as savings and loan associations, thrift
and loan associations, finance companies, credit unions, offerors of money
market funds and other financial institutions.
  The
Bank's primary service area is currently served by branches of eight other banks
(including four major banks:  Citigroup, Bank of America, Wells Fargo
Bank and J.P. Morgan Chase).  In order to compete with the major
financial institutions in its primary service area, the Bank uses its
flexibility as an independent bank.  This includes emphasis on
specialized services and personalized attention.
  In
the event there are customers whose loan demands exceed the Bank's lending
limit, the Bank seeks to arrange for such loans on a participation basis with
other financial institutions and intermediaries.  The Bank also is
able to assist those customers requiring other services not offered by the Bank
by obtaining those services through its correspondent banks.
  Concentration
of Credit Risk
  The
majority of the Bank's loan activity is with customers located within the county
of Sonoma.  While the Bank has a diversified loan portfolio,
approximately 91.3% of these loans are secured by real estate in its service
area.  This concentration for the year ending December 31, 2008 is
presented below:
  (in
      thousands of dollars)Secured
      by real estate:Construction/land
      development
              $
              49,269Farmland
              
              7,5131-4
      family residences
              
              58,278Commercial/multi-family
              
              129,012
     Employees
 
 As
of December 31, 2008, the Company employed 54 full-time equivalent
employees.
 
 5
 Website
Access
 
 We
maintain a website where certain information about the Bank is posted. Through
the website, our annual report on Form 10-K, quarterly reports on Form 10-Q,
current reports on Form 8-K, and amendment to those reports, as well as Section
16 reports and amendments, are available as soon as reasonably practicable after
such material is electronically filed with or furnished to the SEC. These
reports are free of charge and can be accessed through the web address www.SonomaValleyBank.com
by selecting the Investor Relations Tab- SEC Filings link. Further, certain
corporate charters and policies are also posted on this site, and are similarly
available without charge.







Supervision
and Regulation
 
 The
Company is a registered bank holding company under the Bank Holding Company Act,
regulated, supervised and examined by the Federal Reserve Bank
(“FRB”).  As such, it must file with the FRB an annual report and
additional reports as the Federal Reserve Board may require.  The
Company is also subject to periodic examination by the Federal Reserve
Board.
 
 In
addition, both the Company and the Bank are extensively regulated under both
federal and state laws and regulations. These laws and regulations are primarily
intended to protect depositors, not shareholders. To the extent that the
following information describes statutory or regulatory provisions, it is
qualified in its entirety by reference to the particular statutory and
regulatory provisions at issue.
 
 As a
California state-licensed bank, the Bank is subject to regulation, supervision
and periodic examination by the California Department of Financial
Institutions.  The Bank is also subject to regulation, supervision,
and periodic examination by the FDIC.  The Bank is not a member of the
Federal Reserve System, but is nevertheless subject to certain regulations of
the Board of Governors of the Federal Reserve System.  As a state
bank, the Bank's deposits are insured by the FDIC to the maximum amount
permitted by law, which is currently $250,000 per depositor in most
cases.  For this protection, the Bank pays a quarterly
assessment.
 
 The
regulations of these state and federal bank regulatory agencies govern most
aspects of the Company's and the Bank's business and operations, including but
not limited to, requiring the maintenance of non interest-bearing reserves on
deposits, limiting the nature and amount of investments and loans which may be
made, regulating the issuance of securities, restricting the payment of
dividends, regulating bank expansion and bank activities, including real estate
development activities.  The Federal Reserve Board, the FDIC, and the
California Department of Financial Institutions have broad enforcement powers
over depository institutions, including the power to prohibit a bank from
engaging in business practices which are considered to be unsafe or unsound, to
impose substantial fines and other civil and criminal penalties, to terminate
deposit insurance, and to appoint a conservator or receiver under a variety of
circumstances.  The Federal Reserve Board also has broad enforcement
powers over bank holding companies, including the power to impose substantial
fines and other civil and criminal penalties.
  6


Regulation
of Bank Holding Companies
 
 As a bank
holding company, the Company's activities are subject to extensive regulation by
the Federal Reserve Board.  The Bank Holding Company Act requires us
to obtain the prior approval of the Federal Reserve Board before (i) directly or
indirectly acquiring ownership or control of any voting shares of another bank
or bank holding company if, after such acquisition, we would own or control more
than 5% of the shares of the other bank or bank holding company (unless the
acquiring company already owns or controls a majority of such shares); (ii)
acquiring all or substantially all of the assets of another bank or bank holding
company; or (iii) merging or consolidating with another bank holding
company.  The Federal Reserve Board will not approve any acquisition,
merger or consolidation that would have a substantially anticompetitive result,
unless the anticompetitive effects of the proposed transaction are clearly
outweighed by a greater public interest in meeting the convenience and needs of
the community to be served.  The Federal Reserve Board also considers
capital adequacy and other financial and managerial factors in its review of
acquisitions and mergers.
 
 With
certain exceptions, the Bank Holding Company Act also prohibits us from
acquiring or retaining direct or indirect ownership or control of more than 5%
of the voting shares of any company that is not a bank or bank holding company,
or from engaging directly or indirectly in activities other than those of
banking, managing or controlling banks, or providing services for its
subsidiaries.  The principal exceptions to these prohibitions involve
certain non-bank activities that, by statute or by Federal Reserve Board
regulation or order, have been determined to be activities closely related to
the business of banking or of managing or controlling banks.
 
 Federal
Deposit Insurance
 
 The FDIC
may terminate the deposit insurance of any insured depository institution if the
FDIC determines that the institution has engaged or is engaging in unsafe or
unsound practices, is in an unsafe or unsound condition to continue operations
or has violated any applicable law, regulation, order or any condition imposed
in writing by, or pursuant to written agreement with, the FDIC.  The
FDIC may also suspend deposit insurance temporarily during the hearing process
for a permanent termination of insurance if the institution has no tangible
capital.


Impact
of Economic Conditions and Monetary Policies
 
 The
earnings and growth of the Bank are and will be affected by general economic
conditions, both domestic and international, and by the monetary and fiscal
policies of the United States Government and its agencies, particularly the
FRB.  One function of the FRB is to regulate the money supply and the
national supply of bank credit in order to mitigate recessionary and
inflationary pressures.  Among the instruments of monetary policy used
to implement these objects are open market transactions in United States
Government securities, changes in the discount rate on member bank borrowings,
and changes in reserve requirement held by depository
institutions.  The monetary policies of the FRB have had a significant
effect on the operating results of commercial banks in the past and are expected
to continue to do so in the future.  However, the effect of such
policies on the future business and earnings of the Bank cannot be accurately
predicted.
 
 7
 Sarbanes-Oxley
Act of 2002
 
 The Sarbanes-Oxley Act of 2002
(“Sarbanes-Oxley”) intended to address corporate and accounting
fraud.  Sarbanes-Oxley applies to publicly reporting
companies.  In addition to the establishment of a new accounting
oversight board, which will enforce auditing, quality control and independence
standards and will be funded by fees from all publicly traded companies, the
bill restricts provision of both auditing and consulting services by accounting
firms.  To maintain auditor independence, any non-audit services being
provided to an audit client requires pre-approval by the Company’s audit
committee members. In addition, the audit partners must be rotated.
  Sarbanes-Oxley also requires the chief
executive officer and the chief financial officer to certify to the accuracy of
periodic reports filed with the SEC, subject to civil and criminal penalties if
they knowingly or willfully violate this certification
requirement.  In addition, under Sarbanes-Oxley, legal counsel will be
required to report evidence of a material violation of the securities laws or a
breach of fiduciary duty by a company to its chief executive officer or its
chief legal officer, and, if such officer does not appropriately respond, to
report such evidence to the audit committee or other similar committee of the
board of directors or the board itself.  Companies are required to
adopt a Code of Ethics for their Financial Managers and any violators are
subject to disciplinary action.
  Longer prison terms and increased
penalties will also be applied to corporate executives who violate federal
securities laws, the period during which certain types of suits can be brought
against a company or its officers has been extended, and bonuses issued to top
executives prior to restatement of a company’s financial statements are now
subject to disgorgement if such restatement was due to corporate
misconduct.  Executives are also prohibited from insider trading
during retirement plan “blackout” periods, and loans to company executives are
restricted.  Sarbanes-Oxley accelerates the time frame for disclosures
by public companies, as they must immediately disclose any material changes in
their financial condition or operations.  Directors and executive
officers must also provide information for most changes in ownership in a
company’s securities within two business days of the change.


Sarbanes-Oxley also
prohibits any officer or director of a company or any other person acting under
their direction from taking any action to fraudulently influence, coerce,
manipulate or mislead any independent public or certified accountant engaged in
the audit of the company’s financial statements for the purpose of rendering the
financial statements materially misleading.  In addition,
Sarbanes-Oxley requires that each financial report required to be prepared in
accordance with (or reconciled to) accounting principles generally accepted in
the United States of America and filed with the SEC reflect all material
correcting adjustments that are identified by a “registered public accounting
firm” in accordance with accounting principles generally accepted in the United
States of America and the rules and regulations of the SEC.
 
 Section
404 of Sarbanes-Oxley requires the SEC to prescribe rules requiring the
inclusion of an internal control report in each annual
report.  Accordingly, in the annual report for December 31, 2008,
management has included a report on the effectiveness of the Company’s
internal controls.  The Company retained the services of a
consulting firm to assist management and staff with this
process.  There can be no assurances that the evaluation required by
Sarbanes-Oxley will not result in the identification of significant control
deficiencies at some point or that the Company’s auditors will be able to
attest to the effectiveness of our internal controls over financial reporting.
The Company’s independent auditors are required to attest to and report on
management’s assessment of internal control beginning the year ending
December 31, 2009.
 
 8
 Regulation
W
 
 The FRB on October 31, 2002 approved a
final Regulation W that comprehensively implements sections 23A and 23B of the
Federal Reserve Act.  Sections 23A and 23B and Regulation W restrict
loans by a depository institution to its affiliates, asset purchases by a
depository institution from its affiliates, and other transactions between a
depository institution and its affiliates.  Regulation W unifies in
one public document the FRB’s interpretations of sections 23A and
23B.
 
 Regulatory
Capital Treatment of Equity Investments
 
 In December of 2001 and January of
2002, the Office of the Comptroller of the Currency, the FRB and the FDIC
adopted final rules governing the regulatory capital treatment of equity
investments in non-financial companies held by banks, bank holding companies and
financial holding companies.  The new capital requirements apply
symmetrically to equity investments made by banks and their holding companies in
non-financial companies under the legal authorities specified in the final
rules.  Among others, these include the merchant banking authority
granted by the Gramm-Leach-Bliley Act and the authority to invest in small
business investment companies (“SBICs”) granted by the Small Business Investment
Act.  Covered equity investments will be subject to a series of
marginal Tier 1 capital charges, with the size of the charge increasing as the
organization’s level of concentration in equity investments
increases.  The highest marginal charge specified in the final rules
requires a 25 percent deduction from Tier 1 capital for covered investments that
aggregate more than 25 percent of an organization’s Tier 1
capital.  Equity investments through SBICs will be exempt from the new
charges to the extent such investments, in the aggregate, do not exceed 15
percent of the banking organization’s Tier 1 capital.  Grandfathered
investments made by state banks under section 24(f) of the Federal Deposit
Insurance Act also are exempted from coverage.
 
 USA
Patriot Act
 
 The terrorist attacks in September,
2001, have impacted the financial services industry and led to federal
legislation that attempts to address certain issues involving financial
institutions.  On October 26, 2001, President Bush signed into
law the Uniting and Strengthening America by Providing Appropriate Tools
Required to Intercept and Obstruct Terrorism Act of 2001 (the “USA Patriot
Act”).
 
 Part of the USA Patriot Act is the
International Money Laundering Abatement and Financial Anti-Terrorism Act of
2001 (“IMLA”).  IMLA authorizes the Secretary of the Treasury, in
consultation with the heads of other government agencies, to adopt special
measures applicable to banks, bank holding companies, and/or other financial
institutions.  These measures may include enhanced recordkeeping and
reporting requirements for certain financial transactions that are of primary
money laundering concern, due diligence requirements concerning the beneficial
ownership of certain types of accounts, and restrictions or prohibitions on
certain types of accounts with foreign financial
institutions.


9


Among its
other provisions, IMLA requires each financial institution to: (i) establish an
anti-money laundering program; (ii) establish due diligence policies, procedures
and controls with respect to its private banking accounts and correspondent
banking accounts involving foreign individuals and certain foreign banks; and
(iii) avoid establishing, maintaining, administering, or managing correspondent
accounts in the United States for, or on behalf of, a foreign bank that does not
have a physical presence in any country.  In addition, IMLA contains a
provision encouraging cooperation among financial institutions, regulatory
authorities and law enforcement authorities with respect to individuals,
entities and organizations engaged in, or reasonably suspected of engaging in,
terrorist acts or money laundering activities.  IMLA expands the
circumstances under which funds in a bank account may be forfeited and requires
covered financial institutions to respond under certain circumstances to
requests for information from federal banking agencies within 120
hours.  IMLA also amends the Bank Holding Company Act and the Bank
Merger Act to require the federal banking agencies to consider the effectiveness
of a financial institution’s anti-money laundering activities when reviewing an
application under these acts.
  Merchant
Banking Investments
 
 The FRB and the Secretary of the
Treasury in January 2001 jointly adopted a final rule governing merchant banking
investments made by financial holding companies.  The rule implements
provisions of the Gramm-Leach-Bliley Act discussed below that permit financial
holding companies to make investments as part of a bona fide securities
underwriting or merchant or investment banking activity.  The rule
provides that a financial holding company may not, without FRB approval,
directly or indirectly acquire any additional shares, assets or ownership
interests or make any additional capital contribution to any company the shares,
assets or ownership interests of which are held by the financial holding company
subject to the rule if the aggregate carrying value of all merchant banking
investments held by the financial holding company exceeds:
 
 §
              30%
      of the Tier 1 capital of the financial holding company,
  or
 
 §
              after
      excluding interests in private equity funds, 20% of the Tier 1 capital of
      the financial holding company.
 
 A
separate final rule will establish the capital charge of merchant banking
investments for the financial holding company.
 
 Financial
Services Modernization Act of 1999
 
 The Financial Services
Modernization Act of 1999 (also known as the “Gramm-Leach-Bliley Act” after its
Congressional sponsors) substantially eliminates most of the separations between
banks, brokerage firms, and insurers enacted by the Glass-Steagall Act of
1933.  The reform legislation permits securities firms and insurers to
buy banks, and banks to underwrite insurance and securities.  States
retain regulatory authority over insurers.  The Treasury Department’s
Office of the Comptroller of the Currency has authority to regulate bank
subsidiaries that underwrite securities and the Federal Reserve has authority
over bank affiliates for activities such as insurance underwriting and
real-estate development.
 
 10
 The U.S. federal bank regulatory
agencies’ risk-based capital guidelines are based upon the 1988 capital accord
of the Basel Committee on Banking Supervision (the “Basel
Committee”).  The Basel Committee is a committee of central banks and
bank supervisors from the major industrialized countries that develops broad
policy guidelines that each country’s supervisors can use to determine the
supervisory policies they apply.  In January 2001, the Basel Committee
on Banking Supervision issued a proposal for a "New Capital
Accord".  The New Capital Accord incorporates a three-part framework
of minimum capital requirements, supervisory review of an institution's capital
adequacy and internal assessment process, and market discipline through
effective disclosure to encourage safe and sound banking
practices.  To remain a financial holding company, a company must
remain “well capitalized” and “well managed”.  “Well managed” means
that at their most recent examination the bank received a satisfactory composite
rating and at least a satisfactory rating for management.  The federal
banking agencies are required to take "prompt corrective action" in respect of
depository institutions and their bank holding companies that do not meet
minimum capital requirements. FDIC established five capital tiers: "well
capitalized", "adequately capitalized", "undercapitalized", "significantly
undercapitalized" and "critically undercapitalized".  A depository
institution's capital tier, or that of its bank holding company, depends upon
where its capital levels are in relation to various relevant capital measures,
including a risk-based capital measure and a leverage ratio capital measure, and
certain other factors.  As of December 31, 2008, the Company and Bank
are “well capitalized” and “well managed”.


Under the
regulations adopted by the federal banking agencies, a bank holding company is
"well capitalized" if it has (i) a total risk-based capital ratio of 10% or
greater, (ii) a Tier 1 risk-based capital ratio of 6% or greater, (iii) a
leverage ratio of 5% or greater and (iv) is not subject to any written
agreement, order or directive to meet and maintain a specific capital level for
any capital measure. An "adequately capitalized" depository institution is
defined as one that has (i) a total risk-based capital ratio of 8% or greater,
(ii) a Tier 1 risk-based capital ratio of 4% or greater and (iii) a leverage
ratio of 4% or greater (or 3% or greater in the case of a bank rated a composite
1 under the Uniform Financial Institution Rating System, “CAMELS rating”,
established by the Federal Financial Institution Examinations
Council).  A company is considered (i) "undercapitalized" if it has
(A) a total risk-based capital ratio of less than 8%, (B) a Tier 1 risk-based
capital ratio of less than 4% or (C) a leverage ratio of less than 4% (or 3% in
the case of an institution with a CAMELS rating of 1), (ii) "significantly
undercapitalized" if it has (A) a total risk-based capital ratio of less than
6%, or (B) a Tier 1 risk-based capital ratio of less than 3% or (C) a leverage
ratio of less than 3% and (iii) "critically undercapitalized" if it has a ratio
of tangible equity to total assets equal to or less than 2%. An institution may
be deemed by the regulators to be in a capitalization category that is lower
than is indicated by its actual capital position if, among other things, it
receives an unsatisfactory examination rating.
 
 Recent
and Proposed Legislation
 
 From time
to time, legislation is enacted which has the effect of increasing the cost of
doing business, limiting or expanding permissible activities, or affecting the
competitive balance between banks and other financial
institutions.  Proposals to change the laws and regulations governing
the operations and taxation of banks and other financial institutions are
frequently made in Congress, in the California legislature, and by various bank
regulatory agencies.  No prediction can be made as to the likelihood
of any major changes or the impact such changes might have on the
Bank.  Certain changes of potential significance to the Bank which
have been enacted recently or others which are currently under consideration by
Congress or various regulatory or professional agencies are discussed
below.
 
 11
  Emergency
Economic Stabilization Act of 2008.  In
response to global credit and liquidity issues involving a number of financial
institutions, the United States government, particularly the United States
Department of the Treasury (the "Treasury") and the FDIC, have taken a variety
of extraordinary measures designed to restore confidence in the financial
markets and to strengthen financial institutions, including capital injections,
guarantees of bank liabilities and the acquisition of illiquid assets from
banks.
  On
October 3, 2008, the Emergency Economic Stabilization Act of 2008 (the
"EESA") was signed into law. Pursuant to the EESA, the U.S. Treasury was granted
the authority to take a range of actions for the purpose of stabilizing and
providing liquidity to the U.S. financial markets and has proposed several
programs, including the purchase by the U.S. Treasury of certain troubled assets
from financial institutions (the "Troubled Asset Relief Program") and the direct
purchase by the U.S. Treasury of equity of healthy financial institutions (the
"Capital Purchase Program").
 
 On
February 20, 2009, the Company, entered into a Letter Agreement, including
a Securities Purchase Agreement - Standard Terms incorporated
therein  (collectively,  the "Agreement"),  with
the  Treasury  pursuant  to  the Capital
Purchase Program.  Under the  terms of  the
Agreement,  the Company  issued to the Treasury, on February
20, 2009,  8,653 shares of senior preferred stock (“Series A Preferred
Stock”) and a warrant (the "Warrant") to acquire up to  433.00433
shares of a  separate  series of senior preferred stock
(“Series B Preferred  Stock”)  for  an
aggregate  purchase price  of
$8,653,000.  Pursuant to  the  terms  of
the Warrant,  the Treasury  exercised  the Warrant
on February 20, 2009 and  paid the exercise price  by having
the Company withhold, from  the  shares of  Series
B Preferred  Stock  that would otherwise be delivered to the
Treasury upon such exercise, shares of Series B Preferred Stock issuable upon
exercise of the Warrant  with an aggregate liquidation amount equal in
value to the aggregate exercise price of $4.33.
 
 The
Series A Preferred Stock pays cumulative dividends at a rate of 5% per year for
the first five years and at a rate of  9% per year thereafter, but
will be paid only if, as and when declared by the Company's board of
directors.  The Series A Preferred Stock has no maturity date and
ranks senior to the Common Stock with respect to the payment of dividends and
distributions and amounts payable upon liquidation, dissolution and winding up
of the Company.  The Series A Preferred Stock is generally non-voting,
other than class voting on certain matters that could adversely affect the
Series A Preferred Stock.  The Series B Preferred Stock has the same
rights, preferences, privileges, and voting rights as the Series A Preferred
Stock, except that the Series B Preferred Stock will pay dividends immediately
at the rate of 9% per year and may not be redeemed until all the Series A
Preferred Stock has been redeemed.  The Agreement contains limitations
on certain actions of the Company, including, but not limited to, payment of
dividends, redemptions and acquisitions of Company equity
securities.  In addition, the terms Agreement subject the Company to
certain executive compensation limitations as set forth in the
EESA.


12




American
Recovery and Reinvestment Act of 2009. On February 17, 2009, the
American Recovery and Reinvestment Act of 2009 (the "ARRA") was signed into law.
Section 7001 of the ARRA amended Section 111 of the EESA in its
entirety. While the Treasury must promulgate regulations to implement the
restrictions and standards set forth in Section 7001, the ARRA, among other
things, significantly expands the executive compensation restrictions previously
imposed by the EESA. Such restrictions apply to any entity that has received or
will receive financial assistance under the Troubled Asset Recovery Program, and
shall generally continue to apply for as long as any obligation arising from
financial assistance provided under TARP, including preferred stock issued under
the Capital Purchase Program, remains outstanding. These ARRA restrictions shall
not apply to any Troubled Asset Recovery Program recipient during such time when
the federal government (i) only holds any warrants to purchase common stock
of such recipient or (ii) holds no preferred stock or warrants to purchase
common stock of such recipient. As a result of our participation in the Capital
Purchase Program, the restrictions and standards set forth in Section 7001
of the ARRA shall be applicable to the Company, subject to regulations
promulgated by the Treasury. Pursuant to Section 7001(g) of the ARRA, the
Company shall be permitted to repay the capital it received under the Capital
Purchase Program, subject to consultation with the Federal Reserve, without
regard to certain repayment restrictions in the Agreement.







Accounting
Pronouncements





Business
Combinations





In
December 2007, the FASB issued SFAS No. 141, revised, Business
Combinations.  This Statement established principles and
requirements for how the acquirer recognizes and measures in its financial
statements the identifiable assets acquired, the liabilities assumed, and any
noncontrolling interest, recognizes and measures goodwill acquired in a business
combination, and discloses the nature and financial effects of the business
combination.  This Statement applies prospectively to business
combinations for which the acquisition date is on or after December 15,
2008.





Noncontrolling
Interest in Consolidated Financial Statements





In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements—an Amendment of ARB No.
51.  This Statement establishes accounting and reporting
standards for a minority interest in the parent company financial statements and
requires separate identification of equity and net income in the consolidated
financial statements.  This Statement is effective for fiscal years,
and interim periods within those fiscal years, beginning on or after December
15, 2008.





Share
Based Payments as Participating Securities





In June
2008, the Financial Accounting Standard Board (FASB) issued Staff Position No.
EITF 03-6-1 that addresses whether instruments granted in share-based payment
transactions are participation securities prior to vesting and, therefore need
to be included in the earnings allocation in computing earnings per share. This
Staff Position is effective for financial statements issued for the fiscal years
beginning after December 15, 2008.


13


Statistical
Data





The
following information is required by Industry Guide 3, "Statistical Disclosure
by Bank Holding Companies".  The averages shown have been calculated
using the average daily balance.


Sequential PageNumberI.
              
              Distribution
      of Assets, Liabilities and Shareholder’sEquity;
      Interest Rates and DifferentialA.
      Average balance sheets
              
              
              35B.
      Analysis of net interest earnings
              
              
              35C.
      Rate/volume analysis
              
              
              36II.
              
              Investment
      PortfolioA.
      Book value (Amortized Cost) of investments
              
              
              66B.
      Weighted average yield and maturity
              
              
              35,41,48
      and 67C.
      Securities of issuer exceeding ten percent of equity
              
              
              NoneIII.
              
              Loan
      PortfolioA.
      Types of loans
              
              
              35
      and 69B.
      Maturities and sensitivities of loans to change in interest
      rates
              
              
              48
      and 70C.
      Risk elements1.
      Non-accrual, past due, and restructured loans
              
              
              42
      and 702.
      Potential problem loans
              
              
              None3.
      Foreign outstandings
              
              
              None4.
      Loan concentrations
              
              
              41 and
      85D.
      Other Interest-Bearing Assets
              
              
              NoneIV.
              
              Summary
      of Loan Loss Experience
              
              
              42 and
      70V.
              
              DepositsA.
      Average balances and average rates paid
              
              
              35B.
      Other categories of deposits
              
              
              NoneC.
      Foreign outstandings
              
              
              NoneD.
      Maturity of time deposits greater than $100,000
              
              
              48E.
      Maturity of foreign time deposits greater than $100,000
              
              
              NoneVI.
              
              Return
      on Equity and Assets
              
              
              29
      and 32VII.
              
              Short-term
      Borrowings
              
              
              72


14


ITEM
1A.                                RISK
FACTORS.
 
 An investment in the Company’s common stock is
subject to risks inherent to the Company’s business.  The material
risks and uncertainties that management believes affect the Company are
described below.  Before making an investment decision, you should
carefully consider the risks and uncertainties described below together with all
of the other information included or incorporated by reference in this
report.  The risks and uncertainties described below are not the only
ones facing the Company.  Additional risks and uncertainties that
management is not aware of or focused on or that management currently deems
immaterial may also impair the Company’s business operations.  This
report is qualified in its entirety by these risk
factors.
 
 If any of the following risks actually occur, the
Company’s financial condition and results of operations could be materially and
adversely affected. If this were to happen, the value of the Company’s common
stock could decline significantly, and you could lose all or part of your
investment.
 
 Risks Related to the Company’s
Business
 
 The
Company is Subject to Interest Rate Risk
 
 The Company’s earnings and cash flows are largely
dependent upon its net interest income.  Net interest income is the
difference between interest income earned on interest-earning assets such as
loans and securities and interest expense paid on interest-bearing liabilities
such as deposits and borrowed funds.  Interest rates are highly
sensitive to many factors that are beyond the Company’s control, including
general economic conditions and policies of various governmental and regulatory
agencies and, in particular, the Board of Governors of the Federal Reserve
System.  Changes in monetary policy, including changes in interest
rates, could influence not only the interest the Company receives on loans and
securities and the amount of interest it pays on deposits and borrowings, but
such changes could also affect (i) the Company’s ability to originate loans
and obtain deposits, (ii) the fair value of the Company’s financial assets
and liabilities, and (iii) the average duration of the Company’s
mortgage-backed securities portfolio.  If the interest rates paid on
deposits and other borrowings increase at a faster rate than the interest rates
received on loans and other investments, the Company’s net interest income, and
therefore earnings, could be adversely affected.  Earnings could also
be adversely affected if the interest rates received on loans and other
investments fall more quickly than the interest rates paid on deposits and other
borrowings.
 
 Although management believes it has implemented
effective asset and liability management strategies to reduce the potential
effects of changes in interest rates on the Company’s results of operations, any
substantial, unexpected, prolonged change in market interest rates could have a
material adverse effect on the Company’s financial condition and results of
operations.  See Management’s Discussion and Analysis of Financial
Condition and Results of Operations located elsewhere in this report for further
discussion related to the Company’s management of interest rate
risk.
 
 The
Company is Subject to Lending Risk
 
 There are inherent risks associated with the
Company’s lending activities.  These risks include, among other
things, the impact of changes in interest rates and changes in the economic
conditions in the markets where the Company operates as well as those across the
State of California and the United States. Increases in interest rates and/or
weakening economic conditions could adversely impact the ability of borrowers to
repay outstanding loans or the value of the collateral securing these
loans.  The Company is also subject to various laws and regulations
that affect its lending activities.  Failure to comply with applicable
laws and regulations could subject the Company to regulatory enforcement action
that could result in the assessment of significant civil money penalties against
the Company.
 15
 As of December 31, 2008, approximately 91.3% of
the Company’s loan portfolio is directly or indirectly secured by real
property.  Because the Company’s loan portfolio contains a significant
number of construction, commercial and residential real estate loans, the
deterioration of one or a few of these loans could cause a significant increase
in non-performing loans.  An increase in non-performing loans could
result in a net loss of earnings from these loans, an increase in the provision
for possible loan losses and an increase in loan charge-offs, all of which could
have a material adverse effect on the Company’s financial condition and results
of operations.  See Management’s Discussion and Analysis of Financial
Condition and Results of Operations located elsewhere in this report for further
discussion related to commercial and industrial, construction and commercial
real estate loans.
 
 The
Company’s Allowance for Possible Loan Losses may be
Insufficient
 
 The Company maintains an allowance for possible loan
losses, which is a reserve established through a provision for possible loan
losses charged to expense, that represents management’s best estimate of
probable losses that have been incurred within the existing portfolio of
loans.  The allowance, in the judgment of management, is necessary to
reserve for estimated loan losses and risks inherent in the loan
portfolio.  The level of the allowance reflects management’s
continuing evaluation of industry concentrations; specific credit risks; loan
loss experience; current loan portfolio quality; present economic, political and
regulatory conditions and unidentified losses inherent in the current loan
portfolio.  The determination of the appropriate level of the
allowance for possible loan losses inherently involves a high degree of
subjectivity and requires the Company to make significant estimates of current
credit risks and future trends, all of which may undergo material
changes.  Changes in economic conditions affecting borrowers, new
information regarding existing loans, identification of additional problem loans
and other factors, both within and outside of the Company’s control, may require
an increase in the allowance for possible loan losses.  In addition,
bank regulatory agencies periodically review the Company’s allowance for loan
losses and may require an increase in the provision for possible loan losses or
the recognition of further loan charge-offs, based on judgments different than
those of management.  In addition, if charge-offs in future periods
exceed the allowance for possible loan losses; the Company will need additional
provisions to increase the allowance for possible loan losses.  Any
increases in the allowance for possible loan losses will result in a decrease in
net income and, possibly, capital, and may have a material adverse effect on the
Company’s financial condition and results of operations.  See
Management’s Discussion and Analysis of Financial Condition and Results of
Operations located elsewhere in this report for further discussion related to
the Company’s process for determining the appropriate level of the allowance for
possible loan losses.
 
 The
Company is Subject to Environmental Liability Risk Associated with Lending
Activities
 
 A significant portion of the Company’s loan
portfolio is secured by real property.  During the ordinary course of
business, the Company may foreclose on and take title to properties securing
certain loans.  In doing so, there is a risk that hazardous or toxic
substances could be found on these properties.  If hazardous or toxic
substances are found, the Company may be liable for remediation costs, as well
as for personal injury and property damage.  Environmental laws may
require the Company to incur substantial expenses and may materially reduce the
affected property’s value or limit the Company’s ability to use or sell the
affected property.  In addition, future laws or more stringent
interpretations or enforcement policies with respect to existing laws may
increase the Company’s exposure to environmental liability. Although the Company
has policies and procedures to perform an environmental review before initiating
any foreclosure action on real property, these reviews may not be sufficient to
detect all potential environmental hazards.  The remediation costs and
any other financial liabilities associated with an environmental hazard could
have a material adverse effect on the Company’s financial condition and results
of operations.
 16
 The
Company’s Profitability Depends Significantly on Economic Conditions in the
State of California
 
 The Company’s success depends primarily on the
general economic conditions of the State of California and the specific local
markets in which the Company operates.  Unlike larger national or
other regional banks that are more geographically diversified, the Company
provides banking and financial services to customers primarily in Sonoma and its
immediate surrounding towns (the “Sonoma Valley”).  The local
economic conditions in these areas have a significant impact on the demand for
the Company’s products and services as well as the ability of the Company’s
customers to repay loans, the value of the collateral securing loans and the
stability of the Company’s deposit funding sources.  A significant
decline in general economic conditions, caused by inflation, recession, acts of
terrorism, outbreak of hostilities or other international or domestic
occurrences, unemployment, changes in securities markets or other factors could
impact these local economic conditions and, in turn, have a material adverse
effect on the Company’s financial condition and results of
operations.
 
 The
Company Operates in a Highly Competitive Industry and Market
Area
 
 The Company faces substantial competition in all
areas of its operations from a variety of different competitors, many of which
are larger and may have more financial resources.  Such competitors
primarily include national, regional, and community banks within the various
markets the Company operates.  Additionally, various out-of-state
banks have begun to enter or have announced plans to enter the market areas in
which the Company currently operates.  The Company also faces
competition from many other types of financial institutions, including, without
limitation, savings and loans, credit unions, finance companies, brokerage
firms, insurance companies, factoring companies and other financial
intermediaries.  The financial services industry could become even
more competitive as a result of legislative, regulatory and technological
changes and continued consolidation.  Banks, securities firms and
insurance companies can merge under the umbrella of a financial holding company,
which can offer virtually any type of financial service, including banking,
securities underwriting, insurance (both agency and underwriting) and merchant
banking.  Also, technology has lowered barriers to entry and made it
possible for non-banks to offer products and services traditionally provided by
banks, such as automatic transfer and automatic payment systems.  Many
of the Company’s competitors have fewer regulatory constraints and may have
lower cost structures.  Additionally, due to their size, many
competitors may be able to achieve economies of scale and, as a result, may
offer a broader range of products and services as well as better pricing for
those products and services than the Company
can.
 
 The Company’s ability to compete successfully
depends on a number of factors, including, among other
things:
 
 §
                The
      ability to develop, maintain and build upon long-term customer
      relationships based on top quality service, high ethical standards and
      safe, sound assets.
 §
                The
      ability to expand the Company’s market
position.
 §
                The
      scope, relevance and pricing of products and services offered to meet
      customer needs and demands.
 §
                The
      rate at which the Company introduces new products and services relative to
      its competitors.
 §
                Customer
      satisfaction with the Company’s level of
  service.
 §
                Industry
      and general economic trends.
 
 Failure to perform in any of these areas could
significantly weaken the Company’s competitive position, which could adversely
affect the Company’s growth and profitability, which, in turn, could have a
material adverse effect on the Company’s financial condition and results of
operations.
 17
 The
Company is Subject to Extensive Government Regulation and
Supervision
 
 The Company, through its subsidiary Sonoma Valley
Bank, is subject to extensive federal and state regulation and
supervision.  Banking regulations are primarily intended to protect
depositors’ funds, federal deposit insurance funds and the banking system as a
whole, not shareholders.  These regulations affect the Company’s
lending practices, capital structure, investment practices, dividend policy and
growth, among other things.  Congress and federal regulatory agencies
continually review banking laws, regulations and policies for possible
changes.  Changes to statutes, regulations or regulatory policies,
including changes in interpretation or implementation of statutes, regulations
or policies, could affect the Company in substantial and unpredictable
ways.  Such changes could subject the Company to additional costs,
limit the types of financial services and products the Company may offer and/or
increase the ability of non-banks to offer competing financial services and
products, among other things.  Failure to comply with laws,
regulations or policies could result in sanctions by regulatory agencies, civil
money penalties and/or reputation damage, which could have a material adverse
effect on the Company’s business, financial condition and results of
operations.  While the Company has policies and procedures designed to
prevent any such violations, there can be no assurance that such violations will
not occur.  See the section captioned “Supervision and Regulation” in
Item 1.
 
 The
Congressional and regulatory response to the current economic and credit crisis
could have an adverse effect on our business.
  Federal
and state legislators and regulators are expected to pursue increased regulation
of how banks are operated and how loans are originated, purchased, and sold as a
result of the current economic and credit crisis. Changes in the lending market
and secondary markets for loans and related congressional and regulatory
responses may impact how the Bank makes and underwrites loans and otherwise
conducts its business. We are unable to predict whether any legislative or
regulatory initiatives or actions will be implemented, what form they will take,
whether they will be directed at the Bank, or whether such initiatives or
actions, once they are initiated or taken, will thereafter continue to change.
Any such actions could affect us in substantial and unpredictable ways and could
have an adverse effect on our business, financial condition and results of
operations.
 
 The
Company’s Controls and Procedures may Fail or be Circumvented
 
 Management regularly reviews and updates the
Company’s internal controls, disclosure controls and procedures, and corporate
governance policies and procedures.  Any system of controls, however
well designed and operated, is based in part on certain assumptions and can
provide only reasonable, not absolute, assurances that the objectives of the
system are met.  Any failure or circumvention of the Company’s
controls and procedures or failure to comply with regulations related to
controls and procedures could have a material adverse effect on the Company’s
business, results of operations and financial
condition.
 
 New
Lines of Business or new Products and Services may Subject the Company to
Additional Risks
 
 From time to time, the Company may implement new
lines of business or offer new products and services within existing lines of
business.  There are substantial risks and uncertainties associated
with these efforts, particularly in instances where the markets are not fully
developed.  In developing and marketing new lines of business and/or
new products and services the Company may invest significant time and
resources.  Initial timetables for the introduction and development of
new lines of business and/or new products or services may not be achieved and
price and profitability targets may not prove feasible.  External
factors, such as compliance with regulations, competitive alternatives, and
shifting market preferences, may also impact the successful implementation of a
new line of business or a new product or
service.
  18
  Furthermore, any new line of business and/or new
product or service could have a significant impact on the effectiveness of the
Company’s system of internal controls.  Failure to successfully manage
these risks in the development and implementation of new lines of business or
new products or services could have a material adverse effect on the Company’s
business, results of operations and financial
condition.
 
 The Company may
not be able to Attract and Retain Skilled
People
 
 The Company’s success depends, in large part, on its
ability to attract and retain key people. Competition for the best people in
most activities engaged in by the Company can be intense and the Company may not
be able to hire people or to retain them.  The unexpected loss of
services of one or more of the Company’s key personnel could have a material
adverse impact on the Company’s business because of their skills, knowledge of
the Company’s market, years of industry experience and the difficulty of
promptly finding qualified replacement
personnel.
 
 The
Company’s Information Systems may Experience an Interruption or Breach in
Security
 
 The
Company relies heavily on communications and information systems to conduct its
business. Any failure, interruption or breach in security of these systems could
result in failures or disruptions in the Company’s customer relationship
management, general ledger, deposit, loan and other systems.  While
the Company has policies and procedures designed to prevent or limit the effect
of the failure, interruption or security breach of its information systems,
there can be no assurance that any such failures, interruptions or security
breaches will not occur or, if they do occur, that they will be adequately
addressed.  The occurrence of any failures, interruptions or security
breaches of the Company’s information systems could damage the Company’s
reputation, result in a loss of customer business, subject the Company to
additional regulatory scrutiny, or expose the Company to civil litigation and
possible financial liability, any of which could have a material adverse effect
on the Company’s financial condition and results of
operations.
 
 The
Company Continually Encounters Technological Change
 
 The financial services industry is continually
undergoing rapid technological change with frequent introductions of new
technology-driven products and services.  The effective use of
technology increases efficiency and enables financial institutions to better
serve customers and to reduce costs.  The Company’s future success
depends, in part, upon its ability to address the needs of its customers by
using technology to provide products and services that will satisfy customer
demands, as well as to create additional efficiencies in the Company’s
operations.  Many of the Company’s competitors have substantially
greater resources to invest in technological improvements.  The
Company may not be able to effectively implement new technology-driven products
and services or be successful in marketing these products and services to its
customers.  Failure to successfully keep pace with technological
change affecting the financial services industry could have a material adverse
impact on the Company’s business and, in turn, the Company’s financial condition
and results of operations.
 
 The
Company is Subject to Claims and Litigation Pertaining to Fiduciary
Responsibility
 
 From time to time, customers make claims and take
legal action pertaining to the Company’s performance of its fiduciary
responsibilities.  Whether customer claims and legal action related to
the Company’s performance of its fiduciary responsibilities are founded or
unfounded, if such claims and legal actions are not resolved in a manner
favorable to the Company they may result in significant financial liability
and/or adversely affect the market perception of the Company and its products
and services as well as impact customer demand for those products and
services.  Any financial liability or reputation damage could have a
material adverse effect on the Company’s business, which, in turn, could have a
material adverse effect on the Company’s financial condition and results of
operations.
 19
 Severe
Weather, Natural Disasters, Acts of War or Terrorism and Other External Events
Could Significantly Impact the Company’s Business
  Severe weather, natural disasters, acts of war or
terrorism and other adverse external events could have a significant impact on
the Company’s ability to conduct business.  Such events could affect
the stability of the Company’s deposit base, impair the ability of borrowers to
repay outstanding loans, impair the value of collateral securing loans, cause
significant property damage, result in loss of revenue and/or cause the Company
to incur additional expenses.  Although management has established
disaster recovery policies and procedures, the occurrence of any such event
could have a material adverse effect on the Company’s business, which, in turn,
could have a material adverse effect on the Company’s financial condition and
results of operations.
 
 Risks Associated with the Company’s
Common Stock
 
 The
Company’s Stock Price can be Volatile
 
 Stock price volatility may make it more difficult
for you to resell your common stock when you want and at prices you find
attractive. The Company’s stock price can fluctuate significantly in response to
a variety of factors including, among other
things:
 
 §
                Actual
      or anticipated variations in quarterly results of
    operations.
 §
                Recommendations
      by securities analysts.
 §
                Operating
      and stock price performance of other companies that investors deem
      comparable to the Company.
 §
                News
      reports relating to trends, concerns and other issues in the financial
      services industry.
 §
                Perceptions
      in the marketplace regarding the Company and/or its
      competitors.
 §
                New
      technology used, or services offered, by
  competitors.
 §
                Significant
      acquisitions or business combinations, strategic partnerships, joint
      ventures or capital commitments by or involving the Company or its
      competitors.
 §
                Failure
      to integrate acquisitions or realize anticipated benefits from
      acquisitions.
 §
                Changes
      in government regulations.
 §
                Geopolitical
      conditions such as acts or threats of terrorism or military
      conflicts.
 §
                Regional
      disasters, such as wild fires, earthquakes, and floods that may impact the
      Sonoma County region, and specifically our customers businesses, including
      agriculture and tourism.
 §
                Economic
      conditions in the financial industry, including further contractions on
      liquidity of financial institutions, Federal policies on interest rates
      and lending practices, and deterioration in other regional factors such as
      housing and commercial property
defaults.
 General market fluctuations,
industry factors and general economic and political conditions and events, such
as economic slowdowns or recessions, interest rate changes or credit loss
trends, could also cause the Company’s stock price to decrease regardless of
operating results.
  The
Trading Volume in the Company’s Common Stock is Less than that of Other Larger
Financial Services Companies
 
 Although the Company’s common stock is listed for
trading on the OTC Bulletin Board, the trading volume in its common stock is
less than that of other larger financial services companies.  A public
trading market having the desired characteristics of depth, liquidity and
orderliness depends on the presence in the marketplace of willing buyers and
sellers of the Company’s common stock at any given
time.
 20
 This presence depends on the individual decisions of
investors and general economic and market conditions over which the Company has
no control.  Given the lower trading volume of the Company’s common
stock, significant sales of the Company’s common stock, or the expectation of
these sales, could cause the Company’s stock price to
fall.
 
 An
Investment in the Company’s Common Stock is not an Insured
Deposit
 
 The Company’s common stock is not a bank deposit
and, therefore, is not insured against loss by the FDIC, any other deposit
insurance fund or by any other public or private entity.  Investment
in the Company’s common stock is inherently risky for the reasons described in
this “Risk Factors” section and elsewhere in this report and is subject to the
same market forces that affect the price of common stock in any
company.  As a result, if you acquire the Company’s common stock, you
may lose some or all of your investment.
 
 Risks Associated with the Company’s
Industry
 
 The
Earnings of Financial Services Companies are Significantly Affected by General
Business and Economic Conditions
 
 The Company’s operations and profitability are
impacted by general business and economic conditions in the United States and
abroad.  These conditions include short-term and long-term interest
rates, inflation, money supply, political issues, legislative and regulatory
changes, fluctuations in both debt and equity capital markets, broad trends in
industry and finance, and the strength of the U.S. economy and the local
economies in which the Company operates, all of which are beyond the Company’s
control.  A deterioration in economic conditions could result in an
increase in loan delinquencies and non-performing assets, decreases in loan
collateral values and a decrease in demand for the Company’s products and
services, among other things, any of which could have a material adverse impact
on the Company’s financial condition and results of
operations.
 
 Financial
Services Companies Depend on the Accuracy and Completeness of Information About
Customers and Counterparties
 
 In deciding whether to extend credit or enter into
other transactions, the Company may rely on information furnished by or on
behalf of customers and counterparties, including financial statements, credit
reports and other financial information.  The Company may also rely on
representations of those customers, counterparties or other third parties, such
as independent auditors, as to the accuracy and completeness of that
information.  Reliance on inaccurate or misleading financial
statements, credit reports or other financial information could have a material
adverse impact on the Company’s business and, in turn, the Company’s financial
condition and results of operations.
 
 Consumers
may Decide not to use Banks to Complete Their Financial
Transactions
  Technology and other changes are allowing parties to
complete financial transactions that historically have involved banks through
alternative methods.  For example, consumers can now maintain funds
that would have historically been held as bank deposits in brokerage accounts or
mutual funds. Consumers can also complete transactions such as paying bills
and/or transferring funds directly without the assistance of
banks.  The process of eliminating banks as intermediaries, known as
“disintermediation,” could result in the loss of fee income, as well as the loss
of customer deposits and the related income generated from those
deposits.  The loss of these revenue streams and the lower cost
deposits as a source of funds could have a material adverse effect on the
Company’s financial condition and results of
operations.
  21
 ITEM
1B.                                UNRESOLVED
STAFF COMMENTS.
 
 None.
  ITEM
2.                      PROPERTIES
  The Company is headquartered in Sonoma, California.  At the present
time the Company’s Bank has three branch offices.
  The
Sonoma Branch is located at 202 W. Napa Street, Sonoma.  The building
contains approximately 6800 square feet and has been subleased on a long-term
basis (the initial term expires in 2009, with option to extend for two
additional five-year terms).  The office is considered by management
to be well maintained and adequate for the purpose intended.  Lease
payments made in 2008 totaled $273,721 compared to the $263,194 paid in
2007.  The lease provides for future annual rents to be adjusted for
changes in the Consumer Price Index ("CPI"), with a minimum annual increase of
4%, effective each March 1st.
  The
Glen Ellen Branch is located at 13751 Arnold Drive, Glen Ellen.  The
facility is 525 square feet.  The facility is leased for a five year
term expiring in 2013 with the option to extend for one additional five year
term.  Lease payments made in 2008 totaled $15,560 compared to $15,294
in 2007.  The lease provides for future annual rents to be adjusted
for changes in the CPI, with a minimum annual increase of 4% effective April 1st
of each year.
  The
Banco de Sonoma Branch, which opened in March 2004, is located at 18615 Sonoma
Hwy, Suite 108, Boyes Hot Springs, California.  The facility is 1200
square feet.  The facility is leased for a five year term expiring in
2009 with options to extend for two additional five year terms.  Lease
payments in 2008 totaled $20,442 compared to $22,125 in 2007.  The
reduction in lease expense for 2008 was due to a credit adjustment for CAM
charges for prior years.  The lease provides for future annual rents
to be adjusted for changes in the CPI effective February 1st of each
year.
  In
July 1995, the Bank entered into a lease for the building located at 463 Second
Street West (the “Operations Center”).  The building contains
approximately 2400 square feet and has been leased on a long term basis to
coincide with the Sonoma Branch lease.  The initial term and the first
option expired in 2000 and 2005, respectively.  The lease provides for
an additional option to extend for two additional five year terms and one
additional four year term.  Lease payments made in 2008 totaled
$46,113 compared with the $44,578 paid in 2007.  The lease provides
for future annual rents to be adjusted for changes in the CPI effective each
July 1st.
  In
September 1997, the Bank purchased the building and land at 472 Second St. West.
The building contains approximately 1013 square feet.  The Bank paid
$246,943 for the property.  At present the Bank is utilizing the
parking area for additional parking for Bank employees. In September 2007 the
Bank began renting out the building premises. Rental income for 2008 was $15,000
and for 2007 was $5,000.
  In
March 2005, the Bank entered into a lease for the building located at 453 Second
Street West (the “Finance Center”).  The building contains
approximately 1200 square feet.  The facility is leased for a five
year term expiring in February 2010 with the option to renew for two additional
five year terms.  Lease payments paid in 2008 totaled $22,404 compared
with the $21,451 paid in 2007.  The lease provides for future annual
rents to be adjusted for changes in the CPI effective March 15th of each
year.
 
 22
  ITEM
3.                      LEGAL
PROCEEDINGS
 
 In
the normal course of operations, the Company and/or its Bank may have
disagreements or disputes with vendors, borrowers, or employees, which may or
may not result in litigation.  These disputes are seen by the
Company’s management as a normal part of business.  There are no
pending actions reported and no threatened actions that management believes
would have a significant material impact on the Company’s financial position,
results of operations or cash flows.
 
 ITEM
4.                      SUBMISSION
OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
 The
Company did not submit any matters to security holders during the fourth quarter
of its last fiscal year ended December 31, 2008.
  23


PART II
 
 ITEM
5.                      MARKET
FOR THE COMPANY'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS AND ISSUER
PURCHASES OF EQUITY SECURITIES
 
 The
Company’s common stock is quoted on the OTC Bulletin Board under the symbol
"SBNK".  The Company is not listed on any exchange or on the National
Association of Securities Dealers Automated Quotation System
(“NASDAQ”).
 
 Several
brokers act as facilitators in the trades of the Company’s
stock.  They are:




Wachovia
            
            
            
            Monroe
      Securities50
      Old Courthouse Square #110
            
            
            
            100
      N. Riverside Plaza, #1620Santa
      Rosa, CA 95409
            
            
            
            Chicago,
      Il 60606Jody
      Hampton
            
            
            
            Steven
      Schroeder(800)
      356-7022
            
            
            
            (312)
      506-8743Fax
      (707) 528-9728
            
            
            
            Fax
      (312) 506-8799sschroeder@monroesecurities.comHill,
      Thompson, Magid & Co., Inc.
            
            
            
            UBS
      Financial Services15
      Exchange Place, #800
            
            
            
            100
      B. St., Suite #300Jersey
      City, NJ 07302
            
            
            
            Santa
      Rosa, CA 95401Tim
      Padala
            
            
            
            Matthew
      Ricketts(866)
      291-6316 or (201) 369-2908
            
            
            
            (707
      539-1500Fax
      (201) 395-0624
            
            
            
            Fax
      (707) 537-3553ht@hilltompson.comWedbush
      Morgan Securities
            
            
            
            Stone
      & Youngberg LLC4949
      S.W. Meadow Rd. #100
            
            
            
            P.O.
      Box 1688Lake
      Oswego, OR 97035
            
            
            
            42605
      Moonridge RoadLisa
      Gallo
            
            
            
            Big
      Bear, CA 92315Lafayette,
      CA 94549
            
            
            
            Troy
      Norlander(866)
      491-7828
            
            
            
            (800)
      288-2811Direct
      Fax (866) 415-0756
            
            
            
            Fax
      (909) 585-7220Fax
      (503) 675-5037
            
            
            
            tnorlander@syllc.comLisa.gallo@wedbush.comHowe
      Barnes Hoefer & Arnett555
      Market Street, 18th
      FloorSan
      Francisco, CA 94105John
      Cavender(415)
      538-5723 Fax (415) 398-4875Switchboard
      (800) 346-5544


24


The table below summarizes those trades
of the common stock as reported by OTC Bulletin Board, setting forth the high
and low prices for the periods shown.  The stock prices have been
adjusted for stock dividends and stock splits.  These over the counter
quotations reflect inter-dealer prices, without retail mark-up, mark-down or
commission and may not necessarily represent actual transactions.





Quarter
Ended:                                                                                   
 High                Low





December
31,
2008                                                                $22.75           $12.50


September
30,
2008                                                                 22.50            
19.10


June 30,
2008                                                                           25.70            
22.50


March 31,
2008                                                                        27.50             23.00





December
31,
2007                                                                $30.00           $25.15


September
30,
2007                                                                 30.95            
25.10


June 30,
2007                                                                           29.50            
28.35


March 31,
2007                                                                      
 29.50 
           27.75







As of
March 10, 2009 there were 1,026 registered holders of the Company's common
stock, in addition to an unknown number of holders whose shares of common stock
are held in street name.
 
 Payment
of Dividends
 
 Under
state law, the Board of Directors of a California state-licensed bank may
declare a cash dividend, subject to the restriction that the amount available
for the payment of cash dividends shall be the lesser of retained earnings of
the bank or the bank's net income for its last three fiscal years (less the
amount of any distributions to shareholders made during such
period).
 
 However,
under the Financial Institutions Supervisory Act, the FDIC has broad authority
to prohibit a bank from engaging in banking practices which it considers to be
unsafe or unsound.  It is possible, depending upon the financial
condition of the bank in question and other factors, that the FDIC may assert
that the payment of dividends or other payments by a bank is considered an
unsafe and unsound banking practice and therefore, implement corrective action
to address such a practice.




25




Historically,
the Company and the Bank (prior to the formation of the Holding Company) have
declared eleven stock dividends of 5% each, two stock dividends of 10% in
May 1996 and June 1997, a 2 for 1 stock split in March 1998, a 3 for 2 stock
split in July 2004 and ten cash dividends in February 2004, July 2004, February
2005, July 2005, February 2006, August 2006, March 2007, August 2007, March
2008,  September 2008  and March 2009 as detailed
below:
  Dividends Paid by the BankDate
      Declared
              Record
      Date
              Date
      Paid
              Dividend
      PaidMay
      13, 1992
              May
      31, 1992
              June
      15, 1992
              5%
      Stock DividendJune
      26, 1993
              July
      15, 1993
              July
      31, 1993
              5%
      Stock DividendJuly
      20, 1994
              August
      1, 1994
              August
      15, 1994
              5%
      Stock DividendJanuary
      18, 1995
              February
      5, 1995
              February
      20, 1995
              5%
      Stock DividendAugust
      16, 1995
              September
      11, 1995
              September
      29, 1995
              5%
      Stock DividendMay
      22, 1996
              June
      14, 1996
              June
      28, 1996
              10%
      Stock DividendJune
      18, 1997
              July
      15, 1997
              August
      1, 1997
              10%
      Stock DividendMarch
      18, 1998
              April
      15, 1998
              April
      30, 1998
              2
      for 1 Stock SplitJuly
      21, 1999
              August
      16, 1999
              August
      31, 1999
              5%
      Stock DividendAugust
      16, 2000
              September
      8, 2000
              September
      25, 2000
              5%
      Stock DividendDividends Paid by the CompanyDate
      Declared
              Record
      Date
              Date
      Paid
              Dividend
      PaidJuly
      18, 2001
              August
      3, 2001
              August
      17, 2001
              5%
      Stock DividendJune
      17, 2002
              July
      2, 2002
              July
      16, 2002
              5%
      Stock DividendJune
      18, 2003
              July
      2, 2003
              July
      16, 2003
              5%
      Stock DividendFebruary
      18, 2004
              March
      1, 2004
              March
      15, 2004
              $.25
      Cash DividendJuly
      21, 2004
              August
      6, 2004
              August
      26, 2004
              3
      for 2 Stock Split & $.25 Cash DividendFebruary
      16, 2005
              March
      1, 2005
              March
      15, 2005
              $.25
      Cash DividendJuly
      20, 2005
              August
      1, 2005
              August
      15, 2005
              $.25
      Cash DividendFebruary
      15, 2006
              March
      1, 2006
              March
      15, 2006
              $.25
      Cash DividendAugust
      17, 2006
              September
      1, 2006
              September
      15, 2006
              $.30
      Cash DividendFebruary
      22, 2007
              March
      15, 2007
              March
      30, 2007
              $.30
      Cash DividendAugust
      15, 2007
              August
      31, 2007
              September
      14, 2007
              $.30
      Cash DividendFebruary
      20, 2008
              March
      14, 2008
              March
      28, 2008
              $.30
      Cash DividendAugust
      20, 2008
              September
      15, 2008
              September
      30, 2008
              $.30
      Cash DividendFebruary
      18, 2009
              February
      27, 2009
              March
      13, 2009
              $.30
      Cash Dividend


26


Comparison
of Cumulative Total Return on Investment





There can
be no assurance that our stock performance will continue into the future with
the same or similar trends depicted in the graph below.  The market
price of our common stock in recent years has fluctuated significantly and it is
likely that the price of the stock will fluctuate in the future.  We
do not endorse any predictions of future stock
performance.  Furthermore, the stock performance chart is not
considered by us to be (i) soliciting material, (ii) deemed filed with the
Securities and Exchange Commission, or (iii) to be incorporated by reference in
any filings by us under the Securities Act, or the Exchange Act.











Source
      : SNL Financial LC, Charlottesville, VA(434)
      977-1600   www.snl.co

                          ©
      2009


27










The
following chart summarizes the Company repurchases of the Company’s common stock
during the fiscal year ended December 31, 2008.





Period
            (a)
              
              
              
              
              
              Total
      Number of
              Shares
      (or Units)
              Purchased
            (b)
              
              
              
              
              
              
              Average
      Price paid
              per
      Share (or Unit)
            (c)
              
              
              
              Total
      Number of
              Shares
      (or Units)
              Purchased
      as Part
              of
      Publicly
              Announced
      Plans or
              Programs
            (d)
              
              
              
              Maximum
      Number (or Approximate Dollar Value) of Shares (or Units) that May Yet be
      Purchased Under the Plans or    Programs   
      (1) (2)
      (3)10/1/08-
      10/31/08
            815
            $19.10
            815
            38,77711/1/08
      - 11/30/08
            375
            $16.95
            375
            38,40212/1/08
      - 12/31/08
            0
            $ 
      0.00
            0
            38,402Total
            1,190
            $18.42
            1,190





(1)
            On January 17, 2001 a repurchase
      program was approved up to $1,000,000.  On August 21, 2002 an
      additional $1,000,000 was approved.  No
      expiration.


(2)
              On February 15, 2006, 60,000
      shares were approved to repurchase, on October 18, 2006, an additional
      60,000 shares were approved for repurchase and on July 18, 2007, an
      additional 60,000 shares were approved for repurchase.  No
      expiration.(3)
              On
      February 20, 2009, the Company agreed to no longer repurchase shares
      without the approval of the U.S. Treasury as part of their Preferred Stock
      Investment in Sonoma Valley
Bancorp.







28


ITEM
6.                      SELECTED
FINANCIAL DATA
 The
following unaudited selected historical information has been derived from the
audited consolidated financial statements of the Company. The information set
forth below should be read in conjunction with the financial statements, related
Notes thereto, and the section entitled “Management’s Discussion and Analysis of
Financial Condition and Results of Operations” included elsewhere in this
Form 10-K.
 SONOMA VALLEY BANCORP
 Selected Consolidated Financial
Data
 dollars in thousands, except
share
 and per share data
 
 
 For
      the years ended:
                                  
                                  2008
                                  
                                  
                                  2007
                                  
                                  
                                  2006
                                  
                                  
                                  2005
                                  
                                  
                                  2004RESULTS
      OF OPERATIONS:Net
      interest income
                                  
                                  $
                                  14,483
                                  
                                  
                                  $
                                  14,367
                                  
                                  
                                  $
                                  12,922
                                  
                                  
                                  $
                                  11,300
                                  
                                  
                                  $
                                  10,004Provision
      for loan losses
                                  
                                  
                                  (2,110
                                  )
                                  
                                  
                                  (680
                                  )
                                  
                                  
                                  (500
                                  )
                                  
                                  
                                  (360
                                  )
                                  
                                  
                                  (130
                                  )Non-interest
      income
                                  
                                  
                                  2,131
                                  
                                  
                                  
                                  2,279
                                  
                                  
                                  
                                  2,094
                                  
                                  
                                  
                                  1,968
                                  
                                  
                                  
                                  1,710Non-interest
      expense
                                  
                                  
                                  (9,624
                                  )
                                  
                                  
                                  (9,182
                                  )
                                  
                                  
                                  (8,306
                                  )
                                  
                                  
                                  (7,848
                                  )
                                  
                                  
                                  (7,225
                                  )Provision
      for income tax
                                  
                                  
                                  (1,565
                                  )
                                  
                                  
                                  (2,440
                                  )
                                  
                                  
                                  (2,218
                                  )
                                  
                                  
                                  (1,711
                                  )
                                  
                                  
                                  (1,451
                                  )Net
      Income
                                  
                                  $
                                  3,315
                                  
                                  
                                  $
                                  4,344
                                  
                                  
                                  $
                                  3,992
                                  
                                  
                                  $
                                  3,349
                                  
                                  
                                  $
                                  2,908SELECTED
      AVERAGE BALANCES:Assets
                                  
                                  $
                                  301,554
                                  
                                  
                                  $
                                  286,692
                                  
                                  
                                  $
                                  262,090
                                  
                                  
                                  $
                                  232,543
                                  
                                  
                                  $
                                  210,883Loans,
      net of unearned
                                  
                                  
                                  258,191
                                  
                                  
                                  
                                  237,338
                                  
                                  
                                  
                                  199,001
                                  
                                  
                                  
                                  160,655
                                  
                                  
                                  
                                  139,395Deposits
                                  
                                  
                                  241,747
                                  
                                  
                                  
                                  229,105
                                  
                                  
                                  
                                  223,560
                                  
                                  
                                  
                                  203,341
                                  
                                  
                                  
                                  186,496Long-term borrowings
                                  
                                  
                                  16.667
                                  
                                  
                                  
                                  9,192
                                  
                                  
                                  
                                  1,397Shareholders'
      equity
                                  
                                  
                                  30,019
                                  
                                  
                                  
                                  27,248
                                  
                                  
                                  
                                  25,111
                                  
                                  
                                  
                                  21,935
                                  
                                  
                                  
                                  20,799PER
      SHARE DATA:Dividends
                                  
                                  $
                                  0.60
                                  
                                  
                                  $
                                  0.60
                                  
                                  
                                  $
                                  0.55
                                  
                                  
                                  $
                                  0.50
                                  
                                  
                                  $
                                  0.50Basic
      net income
                                  
                                  $
                                  1.46
                                  
                                  
                                  $
                                  1.94
                                  
                                  
                                  $
                                  1.78
                                  
                                  
                                  $
                                  1.54
                                  
                                  
                                  $
                                  1.35Fully
      diluted net income
                                  
                                  $
                                  1.45
                                  
                                  
                                  $
                                  1.88
                                  
                                  
                                  $
                                  1.68
                                  
                                  
                                  $
                                  1.45
                                  
                                  
                                  $
                                  1.25Period
      end book value
                                  
                                  $
                                  13.57
                                  
                                  
                                  $
                                  12.58
                                  
                                  
                                  $
                                  11.71
                                  
                                  
                                  $
                                  10.63
                                  
                                  
                                  $
                                  9.65Weighted
      average shares
                                    outstanding
                                  
                                  
                                  2,263,045
                                  
                                  
                                  
                                  2,241,104
                                  
                                  
                                  
                                  2,247,231
                                  
                                  
                                  
                                  2,170,866
                                  
                                  
                                  
                                  2,148,558Weighted
      average shares
                                    outstanding
      diluted
                                  
                                  
                                  2,292,731
                                  
                                  
                                  
                                  2,313,588
                                  
                                  
                                  
                                  2,369,218
                                  
                                  
                                  
                                  2,303,639
                                  
                                  
                                  
                                  2,330,841FINANCIAL
      RATIOS:Return
      on average assets
                                  
                                  
                                  1.10
                                  %
                                  
                                  
                                  1.52
                                  %
                                  
                                  
                                  1.52
                                  %
                                  
                                  
                                  1.44
                                  %
                                  
                                  
                                  1.38
                                  %Return
      on average
                                    shareholders'
      equity
                                  
                                  
                                  11.04
                                  %
                                  
                                  
                                  15.94
                                  %
                                  
                                  
                                  15.90
                                  %
                                  
                                  
                                  15.27
                                  %
                                  
                                  
                                  13.98
                                  %Net
      yield on earning
                                    assets
                                  
                                  
                                  5.26
                                  %
                                  
                                  
                                  5.51
                                  %
                                  
                                  
                                  5.46
                                  %
                                  
                                  
                                  5.46
                                  %
                                  
                                  
                                  5.48
                                  %Efficiency
      ratio
                                  
                                  
                                  56.78
                                  %
                                  
                                  
                                  53.88
                                  %
                                  
                                  
                                  53.95
                                  %
                                  
                                  
                                  57.44
                                  %
                                  
                                  
                                  59.52
                                  %Average
      shareholders'
                                    equity
      to average assets
                                  
                                  
                                  9.95
                                  %
                                  
                                  
                                  9.50
                                  %
                                  
                                  
                                  9.58
                                  %
                                  
                                  
                                  9.43
                                  %
                                  
                                  
                                  9.86
                                  %CAPITAL
      RATIOS:Risk-based
      capital:Tier
      I
                                  
                                  
                                  10.24
                                  %
                                  
                                  
                                  9.73
                                  %
                                  
                                  
                                  10.26
                                  %
                                  
                                  
                                  10.68
                                  %
                                  
                                  
                                  10.77
                                  %Total
                                  
                                  
                                  11.50
                                  %
                                  
                                  
                                  10.98
                                  %
                                  
                                  
                                  11.51
                                  %
                                  
                                  
                                  11.93
                                  %
                                  
                                  
                                  12.02
                                  %Leverage
      ratio
                                  
                                  
                                  9.38
                                  %
                                  
                                  
                                  9.21
                                  %
                                  
                                  
                                  9.57
                                  %
                                  
                                  
                                  9.61
                                  %
                                  
                                  
                                  9.51
                                  %CREDIT
      QUALITY:Net
      charge-offs to
                                    average
      loans
                                  
                                  
                                  0.31
                                  %
                                  
                                  
                                  0.10
                                  %
                                  
                                  
                                  0.00
                                  %
                                  
                                  
                                  0.01
                                  %
                                  
                                  
                                  0.24
                                  %Allowance
      for possible
                                    loan
      losses to period
                                    end
      loans
                                  
                                  
                                  1.88
                                  %
                                  
                                  
                                  1.49
                                  %
                                  
                                  
                                  1.49
                                  %
                                  
                                  
                                  1.62
                                  %
                                  
                                  
                                  1.59
                                  %
 29
 ITEM
7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
  The
Year Ended December 31, 2008 versus December 31, 2007
 
 The
business operations of the Company continue to be conducted through the Bank,
its wholly-owned subsidiary, which began commercial lending operations on June
3, 1988.  Accordingly, the following discussion and analysis of the
financial condition and the results of operations should be read in conjunction
with the financial statements and notes included elsewhere in this annual
report.  The continued growth and success of the company is dependent
upon a stable economy, an increasing deposit base in the Sonoma Valley and
economically viable technology to enhance customer service.  Expansion
of services in the Sonoma Valley such as the opening of a new branch, the
placement of a remote ATM in the local hospital, and the deployment of wire
transfer services through an international network are some of the strategies
contributing to successful performance.  It is management’s opinion
that community banking will continue to prosper, by providing useful services in
niche markets, in spite of the consolidation taking place in the
industry.
  Critical
Accounting Policies
  The
accounting and reporting policies of the Company conform to accounting
principles generally accepted in the United States and general practices within
the financial services industry.  The preparation of financial
statements in conformity with generally accepted accounting principles requires
management to make estimates and assumptions that affect the amounts reported in
the financial statements and accompanying notes.  Actual results could
differ from those estimates.  A summary of the Company’s most
significant accounting policies is contained on page 61 in Note A to the
consolidated financial statements.  The Company considers its most
critical accounting policies to consist of the allowance for loan and lease
losses and the estimation of fair value, which are separately discussed
below.
  Allowance
for Loan and Lease Losses.  The allowance for loan and lease
losses represents management’s best estimate of inherent losses in the existing
loan portfolio.  The allowance for loan and lease losses is increased
by the provision for losses on loans and leases charged to expense and reduced
by loans and leases charged off, net of recoveries.  The allowance for
loan and lease losses is determined based on management’s assessment of several
factors:  reviews and evaluations of specific loans and leases,
changes in the nature and volume of the loan portfolio, current economic
conditions and the related impact on specific borrowers and industry groups,
historical loan and lease loss experience, the level of classified and
nonperforming loans and the results of regulatory
examinations.
  The
Company’s allowance for loan losses consists of three elements: (i) specific
allocated allowances determined in accordance with SFAS 114 based on probable
losses on specific commercial or commercial  real estate loans; (ii)
risk allocated allowance which is comprised of several loan pool valuation
allowances determined in accordance with SFAS 5 based on Sonoma Valley Bank’s
historical quantitative loan loss experience for similar loans with similar risk
characteristics, including additional qualitative risks and (iii) general
valuation allowances based on existing regional and local economic factors,
including deterioration in commercial and residential real estate values, an
adjustment factor for the current economic cycle the Company is experiencing,
and other judgmental factors supported by qualitative
documentation.
 30
 The
Company’s Audit Committee engages experienced independent loan portfolio review
professionals many of whom are former bank examiners.  The Audit
Committee determines the scope of such reviews and provides the report of
findings to the Board’s Loan Committee after it has reviewed and accepted the
report.  These reviews are supplemented with periodic reviews
internally by the Company’s credit review function, as well as the periodic
examination of both selected credits and the credit review process by the
applicable regulatory agencies.  The information from these reviews
assists management in the timely identification of problems and potential
problems and provides a basis for deciding whether the credit represents a
probable loss or risk that should be recognized.
  Changes in the financial condition of individual borrowers, in economic
conditions, in historical loss experience and in the conditions of the various
markets in which collateral may be sold may all affect the required level of the
allowance for loan and lease losses and the associated provision for loan and
lease losses.
  Financial
Instruments Measured at Fair Value.  The Company’s investment
securities available for sale are carried at fair value with changes in fair
value recognized in other comprehensive income.
 
 Fair
value is defined as the price that would be received to sell an asset or paid to
transfer a liability (i.e.,
the “exit price) in an orderly transaction between market participants at the
measurement date.
 
 In
determining fair value, the Company uses various valuation
approaches.  A hierarchy for inputs is used in measuring fair value
that maximizes the use of observable prices and inputs and minimizes the use of
unobservable prices and inputs by requiring that the observable inputs be used
when available.  The hierarchy is broken down into three levels,
wherein Level 1 uses observable prices in active markets, and Level 3 consists
of valuation techniques that incorporate significant unobservable inputs and
therefore require the greatest use of judgment.  In periods of market
dislocation, such as those experienced in fiscal 2008, the observability of
prices and inputs may be reduced for many instruments.  This condition
could cause an instrument to be reclassified from Level 1 to Level 2 or Level 2
to Level 3.  In addition, a continued downturn in market conditions
could lead to further declines in the valuation of many
instruments.  For further information on the fair value definition,
Level 1, Level 2 and Level 3 hierarchy, and related valuation techniques, see
Note R, page 89 to the consolidated financial statements.
 
 Assets
and Liabilities Measured at Fair Value on a Non-Recurring Basis.Certain
of the Company’s assets were measured at fair value on a non-recurring
basis.  These assets include certain impaired loans and other real
estate that is written down to fair value upon repossession and subsequently
impaired for any further declines in value.  A continued downturn in
market conditions could result in additional impairment charges in future
periods.
 
 For
assets and liabilities measured at fair value on a non-recurring basis, fair
value is determined by using various valuation approaches.  The same
hierarchy as described above, which maximizes the use of observable inputs and
minimizes the use of unobservable inputs, by generally requiring that the
observable inputs be used when available, is used in measuring fair value for
these items.  For further information on financial statement assets
and liabilities that are measured at fair value on a recurring and non-recurring
basis, see Note R, page 89 to the consolidated financial
statements.
 
 31
 Share-Based
Compensation.  We account for share-based awards to employees,
officers, and directors in accordance with the provisions of SFAS No. 123(R),
Share-Based
Payment. Under SFAS No. 123(R), share-based compensation cost is measured
at the grant date, based on the fair value of the award, and is recognized as
expense over the employee’s requisite service period. We adopted SFAS No.
123(R), as required on January 1, 2003. Prior to 2003, we recognized stock-based
compensation expense for employee share-based awards based on their intrinsic
value on the date of grant pursuant to Accounting Principles Board Opinion No.
25, Accounting for
Stock Issued to Employees, and followed the disclosure requirements of
SFAS No. 123, Accounting for
Stock-Based Compensation.
 
 We
grant nonqualified stock options, incentive stock options and restricted stock.
Most of our stock option and restricted stock awards include a service condition
that relates only to vesting. The stock option awards generally vest in three to
five years from the grant date, as does the restricted stock awards.
Compensation expense is amortized on a straight-line basis over the requisite
service period for the entire award, which is generally the maximum vesting
period of the award.
 
 We
use an option-pricing model to determine the grant-date fair value of our stock
options which is affected by assumptions regarding a number of complex and
subjective variables. We make assumptions regarding expected term, expected
volatility, expected dividend yield, and risk-free interest rate in determining
the fair value of our stock options. The expected term represents the
weighted-average period that stock options are expected to remain outstanding.
The expected term assumption is estimated based on the stock options’ vesting
terms and remaining contractual life and employees’ historical exercise
behavior. The expected volatility is based on the historical volatility of our
common stock over a period of time equal to the expected term of the stock
options. The dividend yield assumption is based on the Company’s current
dividend payout rate on its common stock. The risk-free interest rate assumption
is based upon the U.S. Treasury yield curve in effect at the time of grant
appropriate for the term of the employee stock options.
 
 For
restricted share awards, the grant-date fair value is measured at the fair value
of the Company’s common stock as if the restricted share was vested and issued
on the date of the grant.
 
 As
share-based compensation expense under SFAS No. 123(R) is based on awards
ultimately expected to vest, it is reduced for estimated forfeitures. SFAS No.
123(R) requires forfeitures to be estimated at the time of grant and revised, if
necessary, in subsequent periods if actual forfeitures differ from those
estimates. Share-based compensation is discussed in more detail in Notes A and L
to the Company’s consolidated financial statements presented elsewhere in this
report.
  Overview
  We reported net income of $3,315,361 for the
year ending December 31, 2008, a decrease of $1,028,177 over $4,343,538 for the
year ending December 31, 2007.   The decline in earnings is a
result of a $1.4 million increase in the provision for loan loss charged to
expense without which our earnings would be on par with 2007. Non interest
income showed a decline of 6.48% or $148,000 and non interest expense showed an
increase of 4.81% or $442,000.  On a per share basis, net income
equaled $1.46 in 2008 compared with $1.94 per share in 2007.
 
 32
 Return on average total assets for 2008,
2007 and 2006 was 1.10%, 1.52% and 1.52%, respectively.  Return on
average shareholders’ equity declined to 11.04% in 2008 compared to 15.94% in
2007. The $14.9 million growth in average assets from $286.7 to $301.6 and the
$1.0 million decline in net income translate into the lower return on average
assets when compared to prior years. The decline in the return on average equity
is the result of the $2.8 million increase in average equity offset by the $1.0
million decline in net income.
  At December 31, 2008, total assets were
$321.9 million, an 8.1% increase over the $297.9 million at December 31, 2007.
We showed loans net of unearned of $267.4 million in 2008, compared with $250.5
million at year end 2007, an increase of 6.8%. Deposits increased $17.9 million,
growing 7.6%, from $236.0 million at year end 2007 to $253.9 million at year end
2008. Deposit growth continues to be challenging due to competition in the
market from local banks, savings and loans and money market accounts with
brokers and a decline in deposits in our market place. The loan-to-deposit ratio
was 105.3% in 2008 and 106.1% in 2007. In 2009 we anticipate slower growth in
assets, loans and deposits.
 
 Total
shareholders equity increased by $2.9 million or 10.5% during the twelve
months ended December 31, 2008.  At December 31, 2008, we reported net
income of $3,315,361.  In
February, 2008 and in August, 2008 we declared cash dividends which were paid
out in March, 2008 and September, 2008, respectively. In each instance the
amount of the dividend paid was $686,613. In 2004, stock options were granted to
senior employees with a fifth of the options vesting each year over a five year
period.  In 2008, 12,450 options vested which increased equity by
$2,282. The 2004 stock option grant is now fully expensed and the options
are all vested.    In July 2006, 26,000 shares of restricted
stock were granted to senior employees with a fifth of the shares vesting each
year over a five-year period and 3,000 shares of restricted stock were granted
to a senior employee with a third of the shares vesting over a three-year
period.  In 2008, 6,200 shares of restricted stock vested, which
resulted in a tax liability of $14,677. In 2008, equity was increased by
$162,750 to reflect the expense for these shares. In June 2007, 10,000
unqualified stock options were granted to a director with a fifth of the options
vesting each year over a five year period. Additionally, in December, 2007,
7,410 unqualified stock options were granted to two directors with one third
vesting immediately and two thirds vesting over a two year period. In 2008,
equity has been increased by $20,196 and $16,763, respectively, for these 2007
grants. In January 2008, 10,000 incentive stock options were awarded to a senior
employee with a fifth of the options vesting each year over a five year period.
In 2008, equity was increased by $13,664. In April 2008, 10,000 unqualified
stock options were granted to a director with a fifth of the options vesting
each year over a five year period. In 2008 equity was increased $11,899 for
these options.The
net income figure of $3,315,361 reflects an expense for the incentive stock of
$15,947, shares of restricted stock of $162,750, and the unqualified stock
options of $48,858, therefore the net effect of the stock option transactions
relative to equity was zero.  Directors exercised 23,164 options which
added $200,860 to the capital accounts.  The tax benefit of these
options was $158,718, which also increased equity.  Officers exercised
25,874 options which added $381,697 to the capital accounts. During the twelve
months ended December 31, 2008 we repurchased 1,190 shares which lowered equity
by $21,941.  The net effect of this activity results in capital of
$30,860,096 as of December 31, 2008, compared to capital of $27,934,280 as of
December 31, 2007.  See page 57 for detail of “Changes in
Shareholders’ Equity”.
 
 Section
404 of Sarbanes-Oxley Act of 2002 (“Section 404”) requires the Securities and
Exchange Commission (“SEC”) to prescribe rules requiring the establishment,
maintenance and evaluation of an issuer’s internal control of financial
reporting.  We certified compliance in this report for the year ended
December 31, 2008.  Our external independent auditors are required to
attest to and report on management's assessment of internal control over
financial reporting beginning December 31, 2009.  Our management and
staff worked diligently evaluating and documenting the internal control systems
in order to allow our management to report on our internal control over
financial reporting.
 33
  RESULTS
OF OPERATIONS
  Net
Interest Income
 
 Net
interest income is the difference between total interest income and total
interest expense.  Net interest income, adjusted to a fully taxable
equivalent basis, increased minimally by $54,000 to $14.818 million, up .36%
from 2007 net interest income of $14.764 million.  Net interest income
on a fully taxable equivalent basis, as shown on the table - Average Balances,
Yields and Rates Paid on page 35,is higher than net
interest income on the statements of operations because it reflects adjustments
applicable to tax-exempt income from certain securities and loans ($334,000 in
2008 and $397,000 in 2007, based on a 34% federal income tax rate).
 
 Net
interest income for the year ended December 31, 2008 (stated on a fully taxable
equivalent basis) is a result of a $935,000 decline in interest income offset by
a somewhat larger decline of $989,000 in interest expense for a net effect of
$54,000 or .36%. At the beginning of 2008, the fed funds rate and the Wall
street Journal prime rate were at 4.25% and 7.25%, respectively. During the year
the Federal Open Market Committee (FOMC) lowered the fed funds target rate seven
times for a total of 400 basis points. The target fed funds rate is now 0 to
..25% and the Wall Street Journal Prime lending rate is 3.25%.
 
 Net
interest income (stated on a fully taxable equivalent basis) expressed as a
percentage of average earning assets, is referred to as net interest
margin.  Our net interest margin decreased 25 basis points to 5.26%
for 2008 from 5.51% in 2007.  The decrease in the net interest margin
is a result of the stronger growth in earning liabilities causing higher
interest expense when factored against the lower rate of growth in earning
assets.
 
 Interest
Income
 
 As
previously stated, interest income (stated on a fully taxable equivalent basis)
decreased by $935,000 to $20.3 million in 2008, a 4.4% decrease from the $21.2
million realized in 2007.
 
 The
$935,000 decrease in interest income was the result of a $1.2 million increase
due to the growth in volume of average balances, together with a $2.1 million
decrease in income related to lower interest rates paid for a net decrease of
$935,000.  The yield on earning assets was 7.19% as of December 31,
2008 compared to 7.91% in 2007, a 72 basis point decrease. The decrease is
primarily the result of a decline in interest rates paid by
borrowers.
 
 Interest
Expense
 
 Total
interest expense decreased by $989,000 to $5.4 million as of December 31, 2008
compared to $6.4 million in 2007.  The average rate paid on all
interest-bearing liabilities decreased from 3.22% in 2007 to 2.54% in 2008, a 68
basis point decrease.  Average balances on earning liabilities
increased from $199.6 million to $214.7 million, a 7.55% gain in earning
liabilities.
 
 The
gain in volume of average balances was responsible for a $466,000 increase in
interest expense while lower rates paid were responsible for a $1.455 million
decrease in interest expense resulting in a decrease in interest expense of
$989,000.  The decline in rates paid on interest-bearing liability
balances is the primary cause for the decrease in interest expense.
 
 Individual
components of interest income and interest expense are provided in the
table-Average Balances, Yields and Rates Paid on the following
page.
  34


SONOMA
VALLEY BANCORP


AVERAGE BALANCES/YIELDS AND
RATES PAID


Rate/Volume




2008
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              2007
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              2006ASSETS
                                                              
                                                              Average
                                                                Balance
                                                              
                                                              
                                                              Income/
                                                                Expense
                                                              
                                                              
                                                              Yield/
                                                                Rate
                                                              
                                                              
                                                              Average
                                                                Balance
                                                              
                                                              
                                                              Income/
                                                                Expense
                                                              
                                                              
                                                              Yield/
                                                                Rate
                                                              
                                                              
                                                              Average
                                                                Balance
                                                              
                                                              
                                                              Income/
                                                                Expense
                                                              
                                                              
                                                              Yield/
                                                                RateInterest-earning
      assets:Loans(2):Commercial
                                                              
                                                              $
                                                              177,266,393
                                                              
                                                              
                                                              $
                                                              13,154,813
                                                              
                                                              
                                                              
                                                              7.42
                                                              %
                                                              
                                                              $
                                                              158,772,063
                                                              
                                                              
                                                              $
                                                              12,943,010
                                                              
                                                              
                                                              
                                                              8.15
                                                              %
                                                              
                                                              $
                                                              136,909,555
                                                              
                                                              
                                                              $
                                                              10,895,909
                                                              
                                                              
                                                              
                                                              7.96
                                                              %Consumer
                                                              
                                                              
                                                              32,199,803
                                                              
                                                              
                                                              
                                                              2,292,529
                                                              
                                                              
                                                              
                                                              7.12
                                                              %
                                                              
                                                              
                                                              28,115,183
                                                              
                                                              
                                                              
                                                              2,504,305
                                                              
                                                              
                                                              
                                                              8.91
                                                              %
                                                              
                                                              
                                                              25,167,482
                                                              
                                                              
                                                              
                                                              2,065,754
                                                              
                                                              
                                                              
                                                              8.21
                                                              %Real
      estate construction
                                                              
                                                              
                                                              27,247,317
                                                              
                                                              
                                                              
                                                              2,135,850
                                                              
                                                              
                                                              
                                                              7.84
                                                              %
                                                              
                                                              
                                                              30,167,065
                                                              
                                                              
                                                              
                                                              2,640,403
                                                              
                                                              
                                                              
                                                              8.75
                                                              %
                                                              
                                                              
                                                              19,431,136
                                                              
                                                              
                                                              
                                                              1,593,551
                                                              
                                                              
                                                              
                                                              8.20
                                                              %Real
      estate mortgage
                                                              
                                                              
                                                              19,591,931
                                                              
                                                              
                                                              
                                                              1,421,658
                                                              
                                                              
                                                              
                                                              7.26
                                                              %
                                                              
                                                              
                                                              18,460,123
                                                              
                                                              
                                                              
                                                              1,378,532
                                                              
                                                              
                                                              
                                                              7.47
                                                              %
                                                              
                                                              
                                                              15,624,447
                                                              
                                                              
                                                              
                                                              1,088,846
                                                              
                                                              
                                                              
                                                              6.97
                                                              %Tax
      exempt loans (1)
                                                              
                                                              
                                                              2,171,461
                                                              
                                                              
                                                              
                                                              179,250
                                                              
                                                              
                                                              
                                                              8.25
                                                              %
                                                              
                                                              
                                                              2,278,470
                                                              
                                                              
                                                              
                                                              187,389
                                                              
                                                              
                                                              
                                                              8.22
                                                              %
                                                              
                                                              
                                                              2,379,741
                                                              
                                                              
                                                              
                                                              195,558
                                                              
                                                              
                                                              
                                                              8.22
                                                              %Leases
                                                              
                                                              
                                                              19,140
                                                              
                                                              
                                                              
                                                              2,156
                                                              
                                                              
                                                              
                                                              11.26
                                                              %
                                                              
                                                              
                                                              27,221
                                                              
                                                              
                                                              
                                                              2,928
                                                              
                                                              
                                                              
                                                              10.76
                                                              %
                                                              
                                                              
                                                              44,438
                                                              
                                                              
                                                              
                                                              5,185
                                                              
                                                              
                                                              
                                                              11.67
                                                              %Tax
      exempt leases (1)
                                                              
                                                              
                                                              0
                                                              
                                                              
                                                              
                                                              0
                                                              
                                                              
                                                              
                                                              0.00
                                                              %
                                                              
                                                              
                                                              0
                                                              
                                                              
                                                              
                                                              0
                                                              
                                                              
                                                              
                                                              0.00
                                                              %
                                                              
                                                              
                                                              0
                                                              
                                                              
                                                              
                                                              0
                                                              
                                                              
                                                              
                                                              0.00
                                                              %Unearned
      loan fees
                                                              
                                                              
                                                              (305,246
                                                              )
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              (482,421
                                                              )
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              (555,992
                                                              )Total
      loans
                                                              
                                                              
                                                              258,190,799
                                                              
                                                              
                                                              
                                                              19,186,256
                                                              
                                                              
                                                              
                                                              7.43
                                                              %
                                                              
                                                              
                                                              237,337,704
                                                              
                                                              
                                                              
                                                              19,656,567
                                                              
                                                              
                                                              
                                                              8.28
                                                              %
                                                              
                                                              
                                                              199,000,807
                                                              
                                                              
                                                              
                                                              15,844,803
                                                              
                                                              
                                                              
                                                              7.96
                                                              %Investment
      securitiesAvailable
      for sale:Taxable
                                                              
                                                              
                                                              4,199,237
                                                              
                                                              
                                                              
                                                              137,080
                                                              
                                                              
                                                              
                                                              3.26
                                                              %
                                                              
                                                              
                                                              12,659,444
                                                              
                                                              
                                                              
                                                              461,209
                                                              
                                                              
                                                              
                                                              3.64
                                                              %
                                                              
                                                              
                                                              25,545,606
                                                              
                                                              
                                                              
                                                              859,937
                                                              
                                                              
                                                              
                                                              3.37
                                                              %Tax
      exempt (1)
                                                              
                                                              
                                                              0
                                                              
                                                              
                                                              
                                                              0
                                                              
                                                              
                                                              
                                                              0.00
                                                              %
                                                              
                                                              
                                                              0
                                                              
                                                              
                                                              
                                                              0
                                                              
                                                              
                                                              
                                                              0.00
                                                              %
                                                              
                                                              
                                                              0
                                                              
                                                              
                                                              
                                                              0
                                                              
                                                              
                                                              
                                                              0.00
                                                              %Hold
      to maturity:Taxable
                                                              
                                                              
                                                              0
                                                              
                                                              
                                                              
                                                              0
                                                              
                                                              
                                                              
                                                              0.00
                                                              %
                                                              
                                                              
                                                              0
                                                              
                                                              
                                                              
                                                              0
                                                              
                                                              
                                                              
                                                              0.00
                                                              %
                                                              
                                                              
                                                              175,371
                                                              
                                                              
                                                              
                                                              5,128
                                                              
                                                              
                                                              
                                                              2.92
                                                              %Tax
      exempt (1)
                                                              
                                                              
                                                              13,916,098
                                                              
                                                              
                                                              
                                                              803,827
                                                              
                                                              
                                                              
                                                              5.78
                                                              %
                                                              
                                                              
                                                              15,689,127
                                                              
                                                              
                                                              
                                                              980,182
                                                              
                                                              
                                                              
                                                              6.25
                                                              %
                                                              
                                                              
                                                              15,897,167
                                                              
                                                              
                                                              
                                                              920,114
                                                              
                                                              
                                                              
                                                              5.79
                                                              %Total
      investment securities
                                                              
                                                              
                                                              18,115,335
                                                              
                                                              
                                                              
                                                              940,907
                                                              
                                                              
                                                              
                                                              5.19
                                                              %
                                                              
                                                              
                                                              28,348,571
                                                              
                                                              
                                                              
                                                              1,441,391
                                                              
                                                              
                                                              
                                                              5.08
                                                              %
                                                              
                                                              
                                                              41,618,144
                                                              
                                                              
                                                              
                                                              1,785,179
                                                              
                                                              
                                                              
                                                              4.29
                                                              %Federal
      funds sold/Federal Reserve Bank
                                                              
                                                              
                                                              1,824,686
                                                              
                                                              
                                                              
                                                              11,924
                                                              
                                                              
                                                              
                                                              0.65
                                                              %
                                                              
                                                              
                                                              67,123
                                                              
                                                              
                                                              
                                                              3,506
                                                              
                                                              
                                                              
                                                              5.22
                                                              %
                                                              
                                                              
                                                              1,648,644
                                                              
                                                              
                                                              
                                                              74,102
                                                              
                                                              
                                                              
                                                              4.49
                                                              %FHLB
      Stock
                                                              
                                                              
                                                              1,633,447
                                                              
                                                              
                                                              
                                                              88,041
                                                              
                                                              
                                                              
                                                              5.39
                                                              %
                                                              
                                                              
                                                              1,466,403
                                                              
                                                              
                                                              
                                                              69,286
                                                              
                                                              
                                                              
                                                              4.72
                                                              %
                                                              
                                                              
                                                              1,045,871
                                                              
                                                              
                                                              
                                                              50,408
                                                              
                                                              
                                                              
                                                              4.82
                                                              %Total
      Due from Banks/Interest
                                                              
                                                              
                                                              2,194,897
                                                              
                                                              
                                                              
                                                              38,007
                                                              
                                                              
                                                              
                                                              1.73
                                                              %
                                                              
                                                              
                                                              834,271
                                                              
                                                              
                                                              
                                                              29,847
                                                              
                                                              
                                                              
                                                              3.58
                                                              %
                                                              
                                                              
                                                              157,468
                                                              
                                                              
                                                              
                                                              4,977
                                                              
                                                              
                                                              
                                                              3.16
                                                              %Short
      term investments
                                                              
                                                              
                                                              0
                                                              
                                                              
                                                              
                                                              0
                                                              
                                                              
                                                              
                                                              0.00
                                                              %
                                                              
                                                              
                                                              0
                                                              
                                                              
                                                              
                                                              0
                                                              
                                                              
                                                              
                                                              0.00
                                                              %
                                                              
                                                              
                                                              0
                                                              
                                                              
                                                              
                                                              0
                                                              
                                                              
                                                              
                                                              0.00
                                                              %Total
      interest earning assets
                                                              
                                                              
                                                              281,959,164
                                                              
                                                              
                                                              $
                                                              20,265,135
                                                              
                                                              
                                                              
                                                              7.19
                                                              %
                                                              
                                                              
                                                              268,054,072
                                                              
                                                              
                                                              $
                                                              21,200,597
                                                              
                                                              
                                                              
                                                              7.91
                                                              %
                                                              
                                                              
                                                              243,470,934
                                                              
                                                              
                                                              $
                                                              17,759,469
                                                              
                                                              
                                                              
                                                              7.29
                                                              %Noninterest-bearing
      assets:Reserve
      for loan losses
                                                              
                                                              
                                                              (3,979,307
                                                              )
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              (3,620,160
                                                              )
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              (2,995,052
                                                              )Cash
      and due from banks
                                                              
                                                              
                                                              5,534,594
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              5,676,187
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              6,077,171Premises
      and equipment
                                                              
                                                              
                                                              794,831
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              861,563
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              1,078,565Other
      real estate owned
                                                              
                                                              
                                                              246,662
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              0
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              0Other
      assets
                                                              
                                                              
                                                              16,997,701
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              15,720,025
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              14,458,246Total
      assets
                                                              
                                                              $
                                                              301,553,645
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              $
                                                              286,691,687
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              $
                                                              262,089,864LIABILITIES
      AND SHAREHOLDERS’ EQUITYInterest-bearing
      liabilities:Interest-bearing
      depositsInterest-bearing
      transaction
                                                              
                                                              $
                                                              30,129,902
                                                              
                                                              
                                                              $
                                                              49,514
                                                              
                                                              
                                                              
                                                              0.16
                                                              %
                                                              
                                                              $
                                                              29,053,472
                                                              
                                                              
                                                              $
                                                              47,332
                                                              
                                                              
                                                              
                                                              0.16
                                                              %
                                                              
                                                              $
                                                              30,838,635
                                                              
                                                              
                                                              $
                                                              50,928
                                                              
                                                              
                                                              
                                                              0.17
                                                              %Savings
      deposits
                                                              
                                                              
                                                              78,614,676
                                                              
                                                              
                                                              
                                                              1,433,907
                                                              
                                                              
                                                              
                                                              1.82
                                                              %
                                                              
                                                              
                                                              75,703,801
                                                              
                                                              
                                                              
                                                              1,887,350
                                                              
                                                              
                                                              
                                                              2.49
                                                              %
                                                              
                                                              
                                                              73,425,495
                                                              
                                                              
                                                              
                                                              1,363,563
                                                              
                                                              
                                                              
                                                              1.86
                                                              %Time
      less than $100,000
                                                              
                                                              
                                                              32,128,240
                                                              
                                                              
                                                              
                                                              1,138,555
                                                              
                                                              
                                                              
                                                              3.54
                                                              %
                                                              
                                                              
                                                              29,008,487
                                                              
                                                              
                                                              
                                                              1,300,629
                                                              
                                                              
                                                              
                                                              4.48
                                                              %
                                                              
                                                              
                                                              26,544,506
                                                              
                                                              
                                                              
                                                              1,015,391
                                                              
                                                              
                                                              
                                                              3.83
                                                              %Time
      $100,000 and over
                                                              
                                                              
                                                              50,707,135
                                                              
                                                              
                                                              
                                                              1,933,523
                                                              
                                                              
                                                              
                                                              3.81
                                                              %
                                                              
                                                              
                                                              41,397,521
                                                              
                                                              
                                                              
                                                              1,957,123
                                                              
                                                              
                                                              
                                                              4.73
                                                              %
                                                              
                                                              
                                                              38,501,063
                                                              
                                                              
                                                              
                                                              1,602,820
                                                              
                                                              
                                                              
                                                              4.16
                                                              %Total
      interest-bearing deposits
                                                              
                                                              
                                                              191,579,953
                                                              
                                                              
                                                              
                                                              4,555,499
                                                              
                                                              
                                                              
                                                              2.38
                                                              %
                                                              
                                                              
                                                              175,163,281
                                                              
                                                              
                                                              
                                                              5,192,434
                                                              
                                                              
                                                              
                                                              2.96
                                                              %
                                                              
                                                              
                                                              169,309,699
                                                              
                                                              
                                                              
                                                              4,032,702
                                                              
                                                              
                                                              
                                                              2.38
                                                              %Federal
      funds purchased
                                                              
                                                              
                                                              120,218
                                                              
                                                              
                                                              
                                                              2,652
                                                              
                                                              
                                                              
                                                              2.21
                                                              %
                                                              
                                                              
                                                              0
                                                              
                                                              
                                                              
                                                              0
                                                              
                                                              
                                                              
                                                              0.00
                                                              %
                                                              
                                                              
                                                              0
                                                              
                                                              
                                                              
                                                              0
                                                              
                                                              
                                                              
                                                              0.00
                                                              %Long
      term debt & other borrowings
                                                              
                                                              
                                                              22,976,885
                                                              
                                                              
                                                              
                                                              889,470
                                                              
                                                              
                                                              
                                                              3.87
                                                              %
                                                              
                                                              
                                                              24,441,329
                                                              
                                                              
                                                              
                                                              1,244,256
                                                              
                                                              
                                                              
                                                              5.09
                                                              %
                                                              
                                                              
                                                              8,225,343
                                                              
                                                              
                                                              
                                                              425,681
                                                              
                                                              
                                                              
                                                              5.18
                                                              %Total
      interest-bearing liabilities
                                                              
                                                              
                                                              214,677,056
                                                              
                                                              
                                                              $
                                                              5,447,621
                                                              
                                                              
                                                              
                                                              2.54
                                                              %
                                                              
                                                              
                                                              199,604,610
                                                              
                                                              
                                                              $
                                                              6,436,690
                                                              
                                                              
                                                              
                                                              3.22
                                                              %
                                                              
                                                              
                                                              177,535,042
                                                              
                                                              
                                                              $
                                                              4,458,383
                                                              
                                                              
                                                              
                                                              2.51
                                                              %Non
      interest-bearing liabilities:Demand
      deposits
                                                              
                                                              
                                                              50,167,445
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              53,941,828
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              54,250,592Other
      liabilities
                                                              
                                                              
                                                              6,690,052
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              5,897,019
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              5,193,491Shareholders’
      equity
                                                              
                                                              
                                                              30,019,092
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              27,248,230
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              25,110,739Total
      liabilities and shareholders equity
                                                              
                                                              $
                                                              301,553,645
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              $
                                                              286,691,687
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              $
                                                              262,089,864Interest
      rate spread
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              4.65
                                                              %
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              4.68
                                                              %
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              4.78
                                                              %Interest
      income
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              $
                                                              20,265,135
                                                              
                                                              
                                                              
                                                              7.19
                                                              %
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              $
                                                              21,200,597
                                                              
                                                              
                                                              
                                                              7.91
                                                              %
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              $
                                                              17,759,469
                                                              
                                                              
                                                              
                                                              7.29
                                                              %Interest
      expense
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              5,447,621
                                                              
                                                              
                                                              
                                                              1.93
                                                              %
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              6,436,690
                                                              
                                                              
                                                              
                                                              2.40
                                                              %
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              4,458,383
                                                              
                                                              
                                                              
                                                              1.83
                                                              %Net
      interest income/margin
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              $
                                                              14,817,514
                                                              
                                                              
                                                              
                                                              5.26
                                                              %
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              $
                                                              14,763,907
                                                              
                                                              
                                                              
                                                              5.51
                                                              %
                                                              
                                                              
                                                              
                                                              
                                                              
                                                              $
                                                              13,301,086
                                                              
                                                              
                                                              
                                                              5.46
                                                              %





(1)
              Fully
      tax equivalent adjustments are based on a federal income tax rate of 34%
      in 2008, 2007 and 2006(2)
              Non
      accrual loans have been included in loans for the purposes of the above
      presentation.  Loan fees of approximately $353,000, $536,000 and
      $471,000 for the twelve months ended December 31, 2008, 2007 and 2006,
      respectively, were amortized to the appropriate interest income
      categories.




35




SONOMA
VALLEY BANCORP




Rate/Volume
Analysis





2008 over
      2007
                    
                    
                    
                    
                    
                    
                    
                    
                    2007 over
      2006Volume
                    
                    
                    Rate
                    
                    
                    Vol/Rate
                    
                    
                    Total
                    
                    
                    Volume
                    
                    
                    Rate
                    
                    
                    Vol/Rate
                    
                    
                    TotalASSETSInterest-earning
      assets:Loans:Commercial
                    
                    
                    1,507,647
                    
                    
                    
                    (1,160,648
                    )
                    
                    
                    (135,196
                    )
                    
                    
                    211,803
                    
                    
                    
                    1,739,922
                    
                    
                    
                    264,882
                    
                    
                    
                    42,298
                    
                    
                    
                    2,047,101Consumer
                    
                    
                    363,830
                    
                    
                    
                    (502,589
                    )
                    
                    
                    (73,017
                    )
                    
                    
                    (211,776
                    )
                    
                    
                    241,948
                    
                    
                    
                    175,990
                    
                    
                    
                    20,613
                    
                    
                    
                    438,551Real
      estate construction
                    
                    
                    (255,554
                    )
                    
                    
                    (275,681
                    )
                    
                    
                    26,682
                    
                    
                    
                    (504,553
                    )
                    
                    
                    880,455
                    
                    
                    
                    107,179
                    
                    
                    
                    59,218
                    
                    
                    
                    1,046,852Real
      estate mortgage
                    
                    
                    84,519
                    
                    
                    
                    (39,002
                    )
                    
                    
                    (2,391
                    )
                    
                    
                    43,126
                    
                    
                    
                    197,614
                    
                    
                    
                    77,928
                    
                    
                    
                    14,143
                    
                    
                    
                    289,686Tax
      exempt loans
                    
                    
                    (8,801
                    )
                    
                    
                    694
                    
                    
                    
                    (33
                    )
                    
                    
                    (8,139
                    )
                    
                    
                    (8,322
                    )
                    
                    
                    160
                    
                    
                    
                    (7
                    )
                    
                    
                    (8,169
                    )Leases
                    
                    
                    (869
                    )
                    
                    
                    138
                    
                    
                    
                    (41
                    )
                    
                    
                    (772
                    )
                    
                    
                    (2,009
                    )
                    
                    
                    (405
                    )
                    
                    
                    157
                    
                    
                    
                    (2,257
                    )Tax
      exempt leases
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0Unearned
      fee income
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0Total
      loans
                    
                    
                    1,690,772
                    
                    
                    
                    (1,977,087
                    )
                    
                    
                    (183,996
                    )
                    
                    
                    (470,311
                    )
                    
                    
                    3,049,609
                    
                    
                    
                    625,734
                    
                    
                    
                    136,422
                    
                    
                    
                    3,811,764Investment
      securities:Available
      for sale:Taxable
                    
                    
                    (308,222
                    )
                    
                    
                    (47,954
                    )
                    
                    
                    32,047
                    
                    
                    
                    (324,129
                    )
                    
                    
                    (433,784
                    )
                    
                    
                    70,741
                    
                    
                    
                    (35,684
                    )
                    
                    
                    (398,728
                    )Tax-exempt
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0Held
      to maturity:Taxable
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    (5,128
                    )
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    (5,128
                    )Tax-exempt
                    
                    
                    (110,770
                    )
                    
                    
                    (73,941
                    )
                    
                    
                    8,356
                    
                    
                    
                    (176,355
                    )
                    
                    
                    (12,041
                    ))
                    
                    
                    73,065
                    
                    
                    
                    (956
                    )
                    
                    
                    60,068Total
      investment
                      Securities
                    
                    
                    (418,993
                    )
                    
                    
                    (121,894
                    )
                    
                    
                    40,403
                    
                    
                    
                    (500,484
                    )
                    
                    
                    (450,954
                    )
                    
                    
                    143,806
                    
                    
                    
                    (36,640
                    )
                    
                    
                    (343,787
                    )Federal
      funds sold
                    
                    
                    91,802
                    
                    
                    
                    (3,067
                    )
                    
                    
                    (80,316
                    )
                    
                    
                    8,418
                    
                    
                    
                    (71,085
                    )
                    
                    
                    12,011
                    
                    
                    
                    (11,522
                    )
                    
                    
                    (70,596
                    )FHLB
      Stock
                    
                    
                    7,893
                    
                    
                    
                    9,752
                    
                    
                    
                    1,111
                    
                    
                    
                    18,755
                    
                    
                    
                    20,268
                    
                    
                    
                    (992
                    )
                    
                    
                    (399
                    )
                    
                    
                    (18,878
                    )Due
      from banks-int bearing
                    
                    
                    48,678
                    
                    
                    
                    (15,401
                    )
                    
                    
                    (25,117
                    )
                    
                    
                    8,160
                    
                    
                    
                    21,391
                    
                    
                    
                    657
                    
                    
                    
                    2,822
                    
                    
                    
                    24,870Short
      term investments
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0Total
      interest-earning
                      Assets
                    
                    
                    1,420,152
                    
                    
                    
                    (2,107,698
                    )
                    
                    
                    (247,916
                    )
                    
                    
                    (935,462
                    )
                    
                    
                    2,569,229
                    
                    
                    
                    781,216
                    
                    
                    
                    90,683
                    
                    
                    
                    3,441,128LIABILITIESInterest-bearing
      liabilities:Interest-bearing
      deposits:Savings
      deposits
                    
                    
                    1,754
                    
                    
                    
                    413
                    
                    
                    
                    15
                    
                    
                    
                    2,182
                    
                    
                    
                    (2,948
                    )
                    
                    
                    (688
                    )
                    
                    
                    40
                    
                    
                    
                    (3,596
                    )Interest-bearing
      demand
                      Deposits
                    
                    
                    72,570
                    
                    
                    
                    (506,536
                    )
                    
                    
                    (19,477
                    )
                    
                    
                    (453,443
                    )
                    
                    
                    42,310
                    
                    
                    
                    466,987
                    
                    
                    
                    14,490
                    
                    
                    
                    523,787Time
      less than $100,000
                    
                    
                    139,878
                    
                    
                    
                    (272,631
                    )
                    
                    
                    (29,320
                    )
                    
                    
                    (162,074
                    )
                    
                    
                    94,253
                    
                    
                    
                    174,763
                    
                    
                    
                    16,222
                    
                    
                    
                    285,238Time
      $100,000 and over
                    
                    
                    440,124
                    
                    
                    
                    (378,587
                    )
                    
                    
                    (85,138
                    )
                    
                    
                    (23,600
                    )
                    
                    
                    120,581
                    
                    
                    
                    217,369
                    
                    
                    
                    16,353
                    
                    
                    
                    354,303Total
      interest-bearing
                      Deposits
                    
                    
                    654,326
                    
                    
                    
                    (1,157,341
                    )
                    
                    
                    (133,920
                    )
                    
                    
                    (636,935
                    )
                    
                    
                    254,196
                    
                    
                    
                    858,431
                    
                    
                    
                    47,105
                    
                    
                    
                    1,159,732Federal
      funds purchased
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    2,652
                    
                    
                    
                    2,652
                    
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0
                    
                    
                    
                    0Long
      term debit & other borrowing
                    
                    
                    (74,552
                    )
                    
                    
                    (298,095
                    )
                    
                    
                    17,861
                    
                    
                    
                    (354,786
                    )
                    
                    
                    839,216
                    
                    
                    
                    (6,946
                    )
                    
                    
                    (13,694
                    )
                    
                    
                    818,575Total
      interest-bearing
                      Liabilities
                    
                    
                    579,774
                    
                    
                    
                    (1,455,436
                    )
                    
                    
                    (113,407
                    )
                    
                    
                    (989,069
                    )
                    
                    
                    1,093,412
                    
                    
                    
                    851,485
                    
                    
                    
                    33,411
                    
                    
                    
                    1,978,307Interest
      differential
                    
                    
                    840,378
                    
                    
                    
                    (652,262
                    )
                    
                    
                    (134,509
                    )
                    
                    
                    53,607
                    
                    
                    
                    1,475,817
                    
                    
                    
                    (70,269
                    )
                    
                    
                    (57,272
                    )
                    
                    
                    1,462,821





Volume/Rate
      variances were allocated in the following
  manner:


a.  Changes
      affected by volume (change in volume times old
  rate)


b.  Changes
      affected by rates (change in rates times old
  volume)


c.  Changes
      affected by rate/volume (change in volume times change in
      rates)


The
      total for each category was arrived at by totaling the individual items in
      their respective categories.


36


Provision
for Loan Losses
 
 The
provision for loan losses charged to operations as of December 31, 2008 was $2.1
million compared to $680,000 in 2007.  The provision for loan losses
is based on our monthly evaluation of the loan portfolio and the adequacy of the
allowance for loan losses in relation to total loans outstanding.  We
experienced modest loan growth in 2008 and we anticipate loan growth will
continue, which could require additional provisions for loan
losses.  Additionally, there are regulatory concerns about
concentrations of commercial real estate loans among many financial
institutions.  We have a concentration of commercial real estate loans
and although the loans are adequately collateralized, we determined that it is
prudent to continue making a provision for loan losses. In addition to the
above, in recent months the economy has demonstrated weakness and real estate
values have declined. We are monitoring our loan portfolio in order to be aware
of any concerns which may develop.
  At
year end the non-performing assets to total loans ratio was 2.54% as of December
31, 2008 compared to 0.45% in 2007.  Non accrual loans were $6.2
million as of December 31, 2008 compared to $800,000 as of December 31, 2007, an
increase of 680%.  Loans charged-off were $1.028 million and
recoveries were $227,000 for 2008 compared with $251,000 in charge-offs and
$17,000 in recoveries for the same period in 2007.  The increase in
charge offs in 2008 is a result of multiple issues including an increase in
total loans, a significant and growing recession during 2008 which caused more
business failures and borrowers to become delinquent and unable to payback their
loans, and a material drop in real estate values in the Bank’s lending
area.  Refer to page 69,Note D for an analysis in the changes in allowance for loan losses
including charge offs and recoveries.
  Non-interest
Income
  Non-interest
income of $2.1 million for 2008 decreased 6.5% or $148,000 compared to the $2.3
million recorded in 2007.  Of the decrease 52.7% or $78,000 was due to
a decrease in service charges on deposit accounts income, 51.4% was a result of
decreases in other fee income of $76,000 and the category of all other
non-interest income showed an increase of  4.1% or $6,000. The $78,000
decrease in service charge income was a result of a $95,000 decrease in service
charges received for overdrafts and NSF (non sufficient funds) checks. We have
been more proactive closing customer’s accounts which show a strong history of
writing NSF checks and maintaining overdrawn accounts.
  Other
fee income showed a decrease in 2008 of 17.8% or $76,000 from $426,000 in 2007
to $350,000 in 2008.  The decline in income is a result of a decrease
of $39,000 in income we earned from loan referrals, which decreased from $80,000
in 2007 to $41,000 in 2008.  Also contributing to the decrease was a
decline of $16,000 in credit card merchant fee income from $168,000 in 2007 to
$152,000 in 2008 and a decrease of $15,000 in miscellaneous operation income.
Miscellaneous operational income is a category reflecting one time payments or
rebates that are not properly categorized elsewhere. 2007 reflected a higher
number of one time only payments than 2008.
  All
other non-interest income showed a 1.39% increase or $6,000 from $442,000 in
2007 to $448,000 in 2008.  This is largely a result of an increase in
the income generated by bank owned life insurance policies in
2007.  Income on the policies was $423,000 in 2008 compared to
$417,000 in 2007 or yields of 4.00% and 4.14%, respectively. The earnings on
these policies will increase as the balances increase and if market rates
increase, the income produced by these policies should also
increase.
  37
 Non-interest
Expense
  Total
non-interest expense increased 4.8% to $9.6 million in 2008 from $9.2 million in
2007.  Non-interest expense represented 3.19% of average total assets
in 2008 and 3.20% in 2007. The expense/asset ratio is a standard industry
measurement of a bank's ability to control its overhead or non-interest costs.
During 2009, we will continue to emphasize cost controls, although certain
costs, such as costs of company insurance and workers compensation insurance and
medical benefits are not controllable by management.  Refer to Note I,
page 75for
a detailed description of Non-Interest Income and Other Non-Interest
Expense.
  Salaries
and Benefits
  Salary
and benefits increased .42% from $5.587 million in 2007 to $5.610 million in
2008. The increase is a result of an increase of $222,000 in salary expense
which grew from $3.3 million in 2007 to $3.5 million in 2008. At December 31,
2008 and December 31, 2007 total full time equivalent employees were 54 and 51,
respectively an increase of three full time equivalent employees. Also
contributing to the increase is normal merit increases. Year-end assets per
employee were $6.0 million in 2008 compared with $5.8 million in
2007.
  Premises
and Equipment
  Expense
relative to premises and equipment decreased 2.3% to $937,000 in 2008 from
$959,000 in 2007.  Most areas of premises and equipment showed
declines except for lease expense.  Lease expense increased from
$381,000 in 2007 to $393,000 in 2008, a $12,000 (3.36%) increase.  The
Bank continues to emphasize security in its computer
operations.  Equipment and software are monitored and upgraded as
appropriate to ensure confidentiality of customer and Company data contributing
to additional increases in expense.  We continue to emphasize the
utilization of technology to accommodate customer and market
demands.
  Other
Non-interest Expense
  The
most significant dollar increase was in the area of other non-interest expense.
Other non-interest expense showed an increase of 16.7% or $440,000 to $3.1
million in 2008 from $2.6 million in 2007.  The largest percentage of
this increase was due to increases in FDIC and other insurance.  FDIC
and other insurance was $133,000 in 2007 and increased to $264,000 in 2008, an
increase of $131,000 or 29.7% of the total increase of $440,000.  FDIC
assessment showed the most significant increase of $130,000 from $26,000 in 2007
to $156,000 in 2008, an increase of 491.7%. The FDIC recently announced a
special assessment for banks, which will have a significant effect on net income
in 2009.
  Professional
fees represented 22.13% or $98,000 of the $440,000 increase in other
non-interest expense. Professional fees were $1.0 million in 2007 and grew to
$1.1 million in 2008. In 2007 director retirement had a credit balance of
$129,000 due to two director terminations. This year reflected normal expense
for the director retirement accruals which resulted in an increase of
$147,000.
  38
 Loan
expense represented 16.86% or $75,000 of the total increase in other
non-interest expense which grew from $2,000 in 2007 to $76,000 in 2008. Of the
increase $44,000 is expense on foreclosed property which in part reflects a
write down on the value of the property. Loan appraisal expense showed an
increase of $27,000 from a credit balance of $7,000 in 2007 to an expense of
$20,000 in 2008. This is due to the fact that in 2008 we had additional
appraisals performed on our real estate secured loans to analyze our collateral
position.
  Provision
for Income Taxes
  The
provision for income taxes decreased to an effective tax rate of 32.1% in 2008
compared with 36.0% in 2007.  The lower effective tax rate is a
reflection of tax benefits received for options exercised and tax credits
resulting from the bank’s investment in California affordable
housing.  Income taxes reported in the financial statements include
deferred taxes resulting from timing differences in the recognition of items for
tax and financial reporting purposes.


Unaudited
Quarterly Statement of Operations Data





(Dollars in thousands, except per share
data)





Q4
                                                2008
                                              
                                              
                                              
                                              Q3
                                                2008
                                              
                                              
                                              
                                              Q2
                                                2008
                                              
                                              
                                              
                                              Q1
                                                2008
                                              
                                              
                                              
                                              Q4
                                                2007
                                              
                                              
                                              
                                              Q3
                                                2007
                                              
                                              
                                              
                                              Q2
                                                2007
                                              
                                              
                                              
                                              Q1
                                                2007Net
      interest income
                                              
                                              $
                                              3,759
                                              
                                              
                                              $
                                              3,601
                                              
                                              
                                              $
                                              3,552
                                              
                                              
                                              $
                                              3,571
                                              
                                              
                                              $
                                              3,681
                                              
                                              
                                              $
                                              3,571
                                              
                                              
                                              $
                                              3,640
                                              
                                              
                                              $
                                              3,475Provision
      for loan and lease losses
                                              
                                              
                                              (1,280
                                              )
                                              
                                              
                                              (300
                                              )
                                              
                                              
                                              (310
                                              )
                                              
                                              
                                              (220
                                              )
                                              
                                              
                                              (115
                                              )
                                              
                                              
                                              (140
                                              )
                                              
                                              
                                              (290
                                              )
                                              
                                              
                                              (135
                                              )Other
      operating income
                                              
                                              
                                              514
                                              
                                              
                                              
                                              529
                                              
                                              
                                              
                                              531
                                              
                                              
                                              
                                              557
                                              
                                              
                                              
                                              568
                                              
                                              
                                              
                                              582
                                              
                                              
                                              
                                              579
                                              
                                              
                                              
                                              550Other
      operating expenses
                                              
                                              
                                              (2,442
                                              )
                                              
                                              
                                              (2,454
                                              )
                                              
                                              
                                              (2,346
                                              )
                                              
                                              
                                              (2,382
                                              )
                                              
                                              
                                              (2,379
                                              )
                                              
                                              
                                              (2,331
                                              )
                                              
                                              
                                              (2,274
                                              )
                                              
                                              
                                              (2,198
                                              )Income
      before income taxes
                                              
                                              
                                              551
                                              
                                              
                                              
                                              1,376
                                              
                                              
                                              
                                              1,427
                                              
                                              
                                              
                                              1,526
                                              
                                              
                                              
                                              1,755
                                              
                                              
                                              
                                              1,682
                                              
                                              
                                              
                                              1,655
                                              
                                              
                                              
                                              1,692Provision
      for income taxes
                                              
                                              
                                              (126
                                              )
                                              
                                              
                                              (460
                                              )
                                              
                                              
                                              (480
                                              )
                                              
                                              
                                              (499
                                              )
                                              
                                              
                                              (593
                                              )
                                              
                                              
                                              (589
                                              )
                                              
                                              
                                              (582
                                              )
                                              
                                              
                                              (676
                                              )Net
      Income
                                              
                                              
                                              425
                                              
                                              
                                              
                                              916
                                              
                                              
                                              
                                              947
                                              
                                              
                                              
                                              1,027
                                              
                                              
                                              
                                              1,162
                                              
                                              
                                              
                                              1,093
                                              
                                              
                                              
                                              1,073
                                              
                                              
                                              
                                              1,016Per
      share:Basic
      earnings per share
                                              
                                              $
                                              .19
                                              
                                              
                                              $
                                              .41
                                              
                                              
                                              $
                                              .42
                                              
                                              
                                              $
                                              .46
                                              
                                              
                                              $
                                              .52
                                              
                                              
                                              $
                                              .49
                                              
                                              
                                              $
                                              .48
                                              
                                              
                                              $
                                              .45Diluted
      earnings per share
                                              
                                              $
                                              .19
                                              
                                              
                                              $
                                              .40
                                              
                                              
                                              $
                                              .41
                                              
                                              
                                              $
                                              .45
                                              
                                              
                                              $
                                              .50
                                              
                                              
                                              $
                                              .47
                                              
                                              
                                              $
                                              .46
                                              
                                              
                                              $
                                              .43


39


BALANCE
SHEET ANALYSIS
 
 Investment
Securities
 
 Investment
securities were $20.4 million at December 31, 2008, a 10.2% decline from the
$22.8 million at December 31, 2007.  At year end 2008, the overall
portfolio had a market value of $20.6 million compared with an amortized cost of
$20.4 million.  We purchase securities rated A or higher by Standard
and Poor’s and/or Moody’s Investors Service.  In the event a security
is downgraded, we will monitor the investment more closely or sell if
appropriate.  Local tax-exempt bonds are occasionally purchased
without an A rating.
  Securities
are classified as held to maturity (HTM) if we have both the intent and the
ability to hold these securities to maturity.  As of December 31,
2008, we had securities totaling $13.9 million with a market value of $14.0
million categorized as held to maturity.  Decisions to acquire
municipal securities, which are generally placed in this category, are based on
tax planning needs and pledge requirements.
  Securities
are classified as available for sale (AFS) if we intend to hold these debt
securities for an indefinite period of time, but not necessarily to
maturity.  Investment securities which are categorized as available
for sale are acquired as part of the overall asset and liability management
function and serve as a primary source of liquidity.  Decisions to
acquire or dispose of different investments are based on an assessment of
various economic and financial factors, including, but not limited to, interest
rate risk, liquidity and capital adequacy.  Securities held in the
available for sale category are recorded at market value, which is $6.6 million
compared to an amortized cost of $6.6 million as of December 31,
2008.
  There
were sixteen equity securities of $17,000 in the AFS portfolio and five
securities of $1.5 million in the HTM portfolio that are temporarily impaired as
of December 31, 2008. Unrealized losses totaled $31,000 on equity securities and
$100,000 on municipal securities. Of the above, 15 equity securities or $16,000
in the AFS portfolio and five municipal securities of $1.5 million in the HTM
portfolio that have been in a continuous loss position for 12 months or more as
of December 31, 2008.    The primary cause of the impairment
of these securities is interest rate volatility due to market volatility and
downgrades of municipal insurers causing municipal securities to rely on the
underlying rating of the municipality which is typically lower than AAA
rated.  It is our intention to carry the securities to maturity date,
at which time we will receive face value for the securities at no loss. The
equity securities are minimal shares of local and peer group banks so that we
may better review their financial and compensation information.
  Although
the quoted market values fluctuate, investment securities are generally held to
maturity, and accordingly, gains and losses to the income statement are
recognized upon sale, or at such time as management determines that a permanent
decline in value exists.  In our opinion, there was no investment in
securities at December 31, 2008 that constituted a material credit risk to the
Company.  The lower market value to amortized costs was a result of
the increase in market interest rates and not an indication of lower credit
quality. There is some uncertainty in the market relative to the companies
insuring the municipal securities that we hold. We are monitoring this situation
very closely and believe that the municipalities will be able to fulfill their
obligations and there will be no need to rely on the insurance companies for
payment. If the insurance companies are down graded it could lower the rating on
the securities and therefore affect the fair value.
  40
 The
table below shows the components of the investment portfolio and average
yields.  For further information concerning our total securities
portfolio, including market values and unrealized gains and losses, refer to
Note C of the Notes to Consolidated Financial Statements on page
66.





Twelve
      Months Ended 12/31/08
                                        
                                        
                                        
                                        Twelve
      Months Ended 12/31/07Average
                                        
                                        
                                        Income/
                                        
                                        
                                        Yield/
                                        
                                        
                                        
                                        Average
                                        
                                        
                                        Income/
                                        
                                        
                                        Yield/Balance
                                        
                                        
                                        Expense
                                        
                                        
                                        Rate
                                        
                                        
                                        
                                        Balance
                                        
                                        
                                        Expense
                                        
                                        
                                        RateInvestment
      securities:U.S.
      Treasury securities
                                        
                                        $
                                        902,378
                                        
                                        
                                        $
                                        18,457
                                        
                                        
                                        
                                        2.05
                                        %
                                        
                                        
                                        $
                                        2,953,303
                                        
                                        
                                        $
                                        99,747
                                        
                                        
                                        
                                        3.38
                                        %U.S.
      federal agency issues
                                        
                                        
                                        3,270,640
                                        
                                        
                                        
                                        118,062
                                        
                                        
                                        
                                        3.61
                                        %
                                        
                                        
                                        
                                        9,668,731
                                        
                                        
                                        
                                        360,231
                                        
                                        
                                        
                                        3.73
                                        %State,
      county & munis
                                        
                                        
                                        13,916,098
                                        
                                        
                                        
                                        803,827
                                        
                                        
                                        
                                        5.78
                                        %
                                        
                                        
                                        
                                        15,689,127
                                        
                                        
                                        
                                        980,182
                                        
                                        
                                        
                                        6.25
                                        %Other
      securities
                                        
                                        
                                        26,219
                                        
                                        
                                        
                                        561
                                        
                                        
                                        
                                        2.14
                                        %
                                        
                                        
                                        
                                        37,410
                                        
                                        
                                        
                                        1,231
                                        
                                        
                                        
                                        3.29
                                        %Total
      investment securities
                                        
                                        $
                                        18,115,335
                                        
                                        
                                        $
                                        940,907
                                        
                                        
                                        
                                        5.19
                                        %
                                        
                                        
                                        $
                                        28,348,571
                                        
                                        
                                        $
                                        1,441,391
                                        
                                        
                                        
                                        5.08
                                        %




Loans
 
 A
comparative schedule of average loan balances is presented in the table on page
35; year-end balances are presented in Note D to the Consolidated Financial
Statements on page69.
  Loan
balances, net of deferred loan fees at December 31, 2008, were $267.4 million,
an increase of 6.8% over 2007.  Commercial loans, comprising 68.4% of
the portfolio, increased $5.0 million, or 2.8% over 2007 showing the greatest
change in volume of all categories.  Included in Commercial loans are
loans made for commercial purposes and secured by real estate.
  Consumer
loans showed the strongest growth of $7.4 million or 25.3%. The growth is both a
result of new loans as well as advances against existing home equity lines of
credit.
  Real
Estate Mortgage and Real Estate Construction loans also showed growth over 2007
of 12.4% and 8.3% or $2.2 million and $2.1 million, respectively. During 2008 we
were able to continue to expand the real estate mortgage loan portfolio, as Real
Estate Mortgage loans grew from $17.9 million in 2007 to $20.2 million in
2008.  It is anticipated that the growth rate will be more modest in
2009 due to tightened lending standards and declines in property values. Real
Estate Construction loans vary from year to year due to variability in the
construction loans progress and seasonability.  At 2008 year end, Real
Estate Construction loans were $27.9 million, an increase of $2.1 million or
8.3% over $25.8 million as of year end 2007.
  Lease
Financing Receivables showed a decline over 2007.  Lease Financing
Receivables decreased by 18.6% or $4,000 from $22,000 in 2007 to $18,000 in
2008.  Customer interest in lease financing receivables has declined
in our market and we do not see this changing in the foreseeable
future.
 
 Risk
Elements
 
 The
majority of our loan activity is with customers located within Sonoma
County.  Approximately 91.3% of the total loan portfolio is secured by
real estate located in our service area.  Significant concentrations
of credit risk may exist if a number of loan customers are engaged in similar
activities and have similar economic characteristics.  We believe the
Company has policies in place to identify problem loans and to monitor
concentrations of credit (see Note O, on page 84 of the Consolidated Financial
Statements, Concentration of Credit Risk).
  41
 Based
on its risk management review and a review of its loan portfolio, management
believes that its allowance for loan losses as of December 31, 2008, is
sufficient to absorb losses inherent in the loan portfolio.  This
assessment is based upon the best available information and does involve
uncertainty and matters of judgment.  Accordingly, the adequacy of the
loan loss reserve cannot be determined with precision, but is subject to
periodic review, and could be susceptible to significant change in future
periods.


Loan
Commitments and Letters of Credit
 
 Loan
commitments are written agreements to lend to customers at agreed upon terms,
provided there are no violations of any condition established in the
contract.  Commitments generally have fixed expiration dates or other
termination clauses.  Loan commitments may have variable interest
rates and terms that reflect current market conditions at the date of
commitment.  Because many of the commitments are expected to expire
without being drawn upon, the amount of total commitments does not necessarily
represent our anticipated future funding requirements.  Unfunded loan
commitments were $42.3 million at December 31, 2008 and $51.5 million at
December 31, 2007.  The decrease at 2008 year end is partially a
result of advances on existing Real Estate Construction loans as mentioned in
the prior “Loans” section.
  Standby
letters of credit commit us to make payments on behalf of customers when certain
specified events occur.  Standby letters of credit are primarily
issued to support customers' financing requirements of twelve months or less and
must meet our normal policies and collateral requirements.  Standby
letters of credit outstanding were $118,000 at December 31, 2008 and $158,000 at
December 31, 2007.
 
 Nonperforming
Assets
 
 Management
classifies all loans as non-accrual loans when they become more than 90 days
past due as to principal or interest, or when the timely collection of interest
or principal becomes uncertain, if earlier, unless they are adequately secured
and in the process of collection.
  A
loan remains in a non-accrual status until both principal and interest have been
current for six months and meets cash flow or collateral criteria, or when the
loan is determined to be uncollectible and is charged off against the allowance
for loan losses, or in the case of real estate loans, is transferred to other
real estate owned.  A loan is classified as a restructured loan when
the interest rate is reduced, when the term is extended beyond the original
maturity date, or other concessions are made by us, because of the inability of
the borrower to repay the loan under the original terms.
  We
had loans of $6.2 million in non-accrual status at December 31, 2008 and
$800,000 at December 31, 2007.  There were $2.8 million in loans 90
days or more past due at December 31, 2008 and $601,238 in loans 90 days or more
past due at December 31, 2007.  Occasionally, we will have more loans
in non-accrual status than are 90 days past due following the guidelines in the
above paragraph or if management determines the collection of principal or
interest is unlikely.
 
 42
 Allowance
for Loan Losses
 
 The
allowance for loan losses is maintained at a level considered adequate to
provide for losses that can be reasonably anticipated.  The allowance
is increased by provisions charged to operating expense and reduced by
charge-offs, net of recoveries.  The allowance is based on estimates,
and ultimate losses may vary from the current estimates.  These
estimates are reviewed monthly and, as adjustments become necessary, they are
reported in earnings in the periods in which they become known.
  The
review process is intended to identify loan customers who may be experiencing
financial difficulties.  In these circumstances, a specific reserve
allocation or charge-off may be recommended.  Other factors considered
by management in evaluating the adequacy of the allowance
include:  loan volume, historical net loan loss experience, the
condition of industries and geographic areas experiencing or expected to
experience economic adversities, credit evaluations, and current economic
conditions.  The allowance for loan losses is not a precise amount,
but based on the factors above, represents management's best estimate of losses
that may be ultimately realized from the current loan portfolio.
  Worsening
conditions in the general economy and real estate markets will likely continue
to adversely affect the loan portfolio, which could necessitate materially
larger provisions for loan losses than in prior periods. The drastic changes in
the availability of credit during 2008 and continuing into 2009 has negatively
impacted most asset values which serve as collateral to the majority of the
Bank’s loans. However, as of December 31, 2008, we believe the overall allowance
for loan losses is adequate based on our analysis of conditions at that
time.




At
December 31, 2008, the allowance for loan losses was $5.0 million, or 1.88% of
year end loans, compared with $3.7 million or 1.49% of year end loans at
December 31, 2007.  The increase in the allowance is a result of the
loan growth and our review and analysis of the portfolio, due to deterioration
in Real Estate values and poor economic conditions.
 
 Net
charge-offs to average loans increased when compared with the prior
year.  We recorded net losses of $801,000 or .31% of average loans in
2008 compared to net losses of $233.8 in 2007 or .10% of average
loans.  The increase reflects our attention and effort in managing and
collecting past due loans by encouraging the customer to bring them to a current
status or to pay them off and management’s desire to quickly charge off a loan
when it is determined to be uncollectible.  The prompt charge-off of
loans has increased the quality of the loan portfolio.
 
 Deposits
 
 A
comparative schedule of average deposit balances is presented in the table on
page 35;year-end
deposit balances are presented in the table below.
 
 Total
deposits increased $17.9 million or 7.6% in 2008, to $253.9 million compared to
$236.0 million in 2007.  Savings, time deposits greater than $100,000,
other time deposits and interest bearing checking showed increases over 2007.
The deposits showing the strongest growth were savings, which increased $14.8
million or 20.1% from $73.5 million in 2007 to $88.3 million in 2008. This
increase can be attributed to customers opting for liquidity and the low rates
offered on all deposits. Time deposits greater than $100,000 increased $6.5
million or 14.8% from $44.2 million to $50.7 million. Other time deposits grew
to $35.6 million in 2008 from $29.6 million as of year end 2007, growth of $6.0
million or 20.1%. Showing a smaller increase was interest bearing checking,
which increased $928,000 to $31.1 million from $30.1 million.
 
 43
 Non-interest
bearing demand declined $10.3 million or 17.6% from $58.6 million in 2007 to
$48.3 million at year end. Non-interest bearing demand is 19.0% of total
deposits, down from 24.8% at year end 2007.
 
 The
composition of deposits for the years ending December 31, 2008 and 2007 are as
follows:





December
      31,
                    
                    
                    Percentage
                    
                    
                    December
      31,
                    
                    
                    Percentage2008
                    
                    
                    of
      Total
                    
                    
                    2007
                    
                    
                    of
      TotalInterest-bearing
      Transaction Deposits
                    
                    $
                    31,062,597
                    
                    
                    
                    12.2
                    %
                    
                    $
                    30,135,049
                    
                    
                    
                    12.8
                    %Savings
      deposits
                    
                    
                    88,317,397
                    
                    
                    
                    34.8
                    %
                    
                    
                    73,528,081
                    
                    
                    
                    31.1
                    %Time
      deposits, over $100,000
                    
                    
                    50,694,468
                    
                    
                    
                    20.0
                    %
                    
                    
                    44,160,741
                    
                    
                    
                    18.7
                    %Other
      time deposits
                    
                    
                    35,591,280
                    
                    
                    
                    14.0
                    %
                    
                    
                    29,634,626
                    
                    
                    
                    12.6
                    %Total
      interest-bearing deposits
                    
                    
                    205,665,742
                    
                    
                    
                    81.0
                    %
                    
                    
                    177,458,497
                    
                    
                    
                    75.2
                    %Noninterest-bearing
      demand
                    
                    
                    48,279,759
                    
                    
                    
                    19.0
                    %
                    
                    
                    58,589,202
                    
                    
                    
                    24.8
                    %Total
      deposits
                    
                    $
                    253,945,501
                    
                    
                    
                    100.0
                    %
                    
                    $
                    236,047,699
                    
                    
                    
                    100.0
                    %


Capital
 
 The
Bank is subject to FDIC regulations governing capital adequacy.  The
FDIC has adopted risk-based capital guidelines which establish a risk-adjusted
ratio relating capital to different categories of assets and off-balance sheet
exposures.  Under the current guidelines, as of December 31, 2008, the
Bank was required to have minimum Tier I and total risk-based capital ratios of
4% and 8%, respectively. To be well capitalized under Prompt Corrective Action
Provisions requires minimum Tier I and total risk-based capital ratios to be 6%
and 10%, respectively.
  The
FDIC has also adopted minimum leverage ratio guidelines for compliance by
banking organizations.  The guidelines require a minimum leverage
ratio of 4% of Tier 1 capital to total average assets.  Banks
experiencing high growth rates are expected to maintain capital positions well
above the minimum levels.  The leverage ratio, in conjunction with the
risk-based capital ratio, constitutes the basis for determining the capital
adequacy of banking organizations.
  Based
on the FDIC's guidelines, the Bank's total risk-based capital ratio at December
31, 2008 was 11.32% and its Tier 1 risk-based capital ratio was
10.06%.  The Bank's leverage ratio was 9.22%.  All the
ratios exceed the minimum guidelines of 8.00%, 4.00% and 4.00%,
respectively.  The total risk based capital, Tier 1 risk based capital
and leverage ratios for the Company at December 31, 2007, were 10.98%, 9.73% and
9.21%, respectively.  The capital ratios for the Company at December
31, 2008, were 11.50%, 10.24% and 9.38%, respectively.
  In
November 2008, the company applied for funds through the U.S. Treasury’s Capital
Purchase Program. On December 17, 2008, we were preliminarily approved to
receive capital in the form of Senior Preferred shares of $8,653,000. This
preliminary approval was pending shareholder approval of a change to our
Articles of Incorporation allowing us to issue preferred shares. On February 11,
2009 shareholder approval was received and the Articles of Incorporation were
amended. On February 20, 2009, the Company entered into a Letter
Agreement with the United States Department
of the Treasury pursuant to the Troubled Asset
Relief Program Capital Purchase Program.  Under the  terms
of  the Letter Agreement,  the Company  issued to
the Treasury,  8,653 shares of senior preferred stock and a warrant to
acquire up to  433.00433 shares of a  separate series of
senior preferred stock for  an aggregate  purchase
price  of $8,653,000, pursuant to the  standard Capital
Purchase Program terms and conditions for  non-public
companies.
  44
 In
February 2001, we approved a program to repurchase Sonoma Valley Bancorp stock
up to $1.0 million and in August 2002 we approved the repurchase of an
additional $1.0 million of Sonoma Valley Bancorp stock.  As of
December 31, 2005, $1,580,162 had been repurchased and retired, net of options
which were exercised and then subsequently repurchased and
retired.  In February 2006 we approved the repurchase of 60,000 shares
of Sonoma Valley Bancorp stock, in October 2006 we approved an additional 60,000
shares of Sonoma Valley Bancorp stock and in July, 2007 we approved an
additional 60,000 shares of Sonoma Valley Bancorp stock.  During the
twelve months ended December 31, 2006, 55,028 shares were repurchased and
retired of which 15,035 shares or $364,729 were a part of the amount approved
August 2002.   During the twelve months ended December 31, 2007,
100,415 shares were repurchased and retired.  During the twelve months
ended December 31, 2008, 1,190 shares have been repurchased and retired. Refer
to page 33, for a discussion of the changes in capital and pages 57 and
58 for the table of “Changes in Shareholders’ Equity.”
  We
believe that the Bank's current capital position, which exceeds guidelines
established by industry regulators, is adequate to support our
business.




Off
Balance Sheet Commitments and Contractual Obligations
 
 Our
off balance sheet commitments consist of commitments to extend credit and
standby letters of credit.  These commitments are extended to
customers in the normal course of business and are described on page 42, Loan
Commitments and Letters of Credit and in Note N to the Consolidated Financial
Statements on page 83.  We also have contractual obligations
consisting of operating leases for various facilities and payments to
participants under our supplemental executive retirement plan, director
retirement plan and deferred compensation plan, which are described in Note H on
page73.
  The
following table summarizes our contractual obligations as of December 31,
2008.





Payments
      due by periodContractual
      Obligations
                                                                          
                                                                          Total
                                                                          
                                                                          
                                                                          Less
      than 1 year
                                                                          
                                                                          
                                                                          1-3
      years
                                                                          
                                                                          
                                                                          3-5 Years
                                                                          
                                                                          
                                                                          More
      than 5 yearsOperating
      Lease Obligations
                                                                          
                                                                          $
                                                                          432,680
                                                                          
                                                                          
                                                                          $
                                                                          249,422
                                                                          
                                                                          
                                                                          $
                                                                          108,487
                                                                          
                                                                          
                                                                          $
                                                                          72,651
                                                                          
                                                                          
                                                                          $
                                                                          2,120Executive
      Officer Supplemental Retirement
                                                                          
                                                                          $
                                                                          10,475,933
                                                                          
                                                                          
                                                                          $
                                                                          225,109
                                                                          
                                                                          
                                                                          $
                                                                          577,495
                                                                          
                                                                          
                                                                          $
                                                                          704,772
                                                                          
                                                                          
                                                                          $
                                                                          8,968,557Federal
      Home Loan Bank - Long Term Borrowings
                                                                          
                                                                          $
                                                                          30,000,000
                                                                          
                                                                          
                                                                          $
                                                                          25,000,000
                                                                          
                                                                          
                                                                          $
                                                                          5,000,000
                                                                          
                                                                          
                                                                          
                                                                          --
                                                                          
                                                                          
                                                                          
                                                                          --Director
      Retirement Plan
                                                                          
                                                                          $
                                                                          1,050,518
                                                                          
                                                                          
                                                                          $
                                                                          10,200
                                                                          
                                                                          
                                                                          $
                                                                          39,337
                                                                          
                                                                          
                                                                          $
                                                                          89,455
                                                                          
                                                                          
                                                                          $
                                                                          911,636Deferred
      Compensation
                                                                          
                                                                          $
                                                                          4,614,626
                                                                          
                                                                          
                                                                          $
                                                                          242,891
                                                                          
                                                                          
                                                                          $
                                                                          569,969
                                                                          
                                                                          
                                                                          $
                                                                          644,919
                                                                          
                                                                          
                                                                          $
                                                                          3,156,847







45


Liquidity
Management and Capital Resources





Our
liquidity is determined by the level of assets (such as cash, federal funds sold
and available-for-sale securities) that are readily convertible to cash to meet
customer withdrawal and borrowing needs.  Deposit growth also
contributes to our liquidity.  We review our liquidity position on a
regular basis to verify that it is adequate to meet projected loan funding and
potential withdrawal of deposits.  We have a comprehensive Asset and
Liability Policy which we use to monitor and determine adequate levels of
liquidity.  At year end 2008, our primary liquidity ratio (adjusted
liquid assets to deposits and short term liabilities) was 7.72% compared to 5.9%
and 11.4% at year end 2007 and 2006, respectively.  Available
liquidity which includes the ability to borrow at the Federal Home Loan Bank and
CDARS deposits were 27.1% or $87.1 million in December 31, 2008 and 29.4% or
$87.1 million and 38.2% or $106.0 million in 2007 and 2006,
respectively.  Management expects that liquidity will remain adequate
throughout 2009, if deposits continue to grow. Any excess funds will be invested
in quality liquid assets, such as U.S. Treasury and Agency
securities.  Management believes that the Company has adequate
liquidity and capital resources to meet its short term and long term
commitments.





Market
Risk Management
 
 Overview.  Market
risk is the risk of loss from adverse changes in market prices and
rates.  Our market risk arises primarily from interest rate risk
inherent in our loan, investment and deposit functions.  The goal for
managing our assets and liabilities is to maximize shareholder value and
earnings while maintaining a high quality balance sheet without exposing us to
undue interest rate risk.  Our Board of Directors has overall
responsibility for the interest rate risk management policies.  Sonoma
Valley Bank has an Asset and Liability Management Committee (ALCO) that
establishes and monitors guidelines to control the sensitivity of earnings to
changes in interest rates.
  Asset/Liability
Management.  Activities involved in asset/liability management
include but are not limited to lending, accepting and placing deposits and
investing in securities.  Interest rate risk is the primary market
risk associated with asset/liability management.  Sensitivity of
earnings to interest rate changes arises when yields on assets change in a
different time period or in a different amount from that of interest costs on
liabilities.  To mitigate interest rate risk, the structure of the
balance sheet is managed with the goal that movements of interest rates on
assets and liabilities are correlated and contribute to earnings even in periods
of volatile interest rates.  When interest rates increase, the market
value of securities held in the investment portfolio
declines.  Generally, this decline is offset by an increase in
earnings.  When interest rates decline, the market value of securities
increases while earnings decrease due to our asset sensitivity caused by the
variable rate loans.  Usually we are able to mitigate the risk from
changes in interest rates with this balance sheet
structure.   The asset/liability management policy sets limits on
the acceptable amount of variance in net interest margin and market value of
equity under changing interest environments.  We use simulation models
to forecast earnings, net interest margin and market value of
equity.
  Simulation
of earnings is the primary tool used to measure the sensitivity of earnings to
interest rate changes.  Using computer-modeling techniques, we are
able to estimate the potential impact of changing interest rates on
earnings.  A balance sheet forecast is prepared quarterly using inputs
of actual loans, securities and interest bearing liabilities (i.e.
deposits/borrowings) positions as the beginning base.  The forecast
balance sheet is processed against five interest rate scenarios.  The
scenarios include 100 and 200 basis point rising rate forecasts, a flat rate
forecast and 100 and 200 basis point falling rate forecasts which take place
within a one year time frame.  The net interest income is measured
during the year assuming a gradual change in rates over the twelve-month
horizon.
  46
 Our
2009 net income, as forecast below, was modeled utilizing a forecast balance
sheet projected from year end 2008 balances.  The following table
summarizes the effect on net income of +100, +200 and +300 basis point changes
in interest rates as measured against a constant rate (no change)
scenario.
  Interest
Rate Risk Simulation of Net Income as of December 31, 2008
 (In
thousands)





Variation
      from a constant rate scenario
                      
                      
                      $
      Change in Net Income+300bp
                      
                      
                      (162)+200bp
                      
                      
                      (199)+100bp
                      
                      
                      (146)


The
simulations of earnings do not incorporate any management actions, which might
moderate the negative consequences of interest rate
deviations.  Therefore, they do not reflect likely actual results, but
serve as conservative estimates of interest rate risk.  Since the
primary tool used by management to measure and manage interest rate exposure is
a simulation model, use of the model to perform simulations reflecting changes
in interest rates over a twelve month horizon enables management to develop and
initiate strategies for managing exposure to interest rate risks.  Our
management believes that both individually and in the aggregate its modeling
assumptions are reasonable, but the complexity of the simulation modeling
process results in a sophisticated estimate, not an absolutely precise
calculation of exposure.
 
 Interest Rate Sensitivity
Analysis.  Interest rate sensitivity is a function of the
repricing characteristics of the portfolio of assets and
liabilities.  These repricing characteristics are the time frames
within which the interest-bearing assets and liabilities are subject to change
in interest rates either at replacement, repricing or
maturity.  Interest rate sensitivity management focuses on the
maturity of assets and liabilities and their  repricing during periods
of changes in market interest rates.  Interest rate sensitivity is
measured as the difference between the volumes of assets and liabilities in the
current portfolio that are subject to repricing at various time
horizons.  The differences are known as interest sensitivity
gaps.
 
 A
positive cumulative gap may be equated to an asset sensitive
position.  An asset sensitive position in a rising interest rate
environment will cause a bank’s interest rate margin to expand.  This
results as floating or variable rate loans reprice more rapidly than fixed rate
certificates of deposit that reprice as they mature over
time.  Conversely, a declining interest rate environment will cause
the opposite effect.  A negative cumulative gap may be equated to a
liability sensitive position.  A liability sensitive position in a
rising interest rate environment will cause a bank’s interest rate margin to
contract, while a declining interest rate environment will have the opposite
effect.  The table above shows net interest income declining both when
rates increase and when rates decline.  Although we are usually asset
sensitive, which would cause the Bank’s net interest margin to expand when rates
increase, the simulation is showing a negative change in net interest income
both in a rising and declining rate environment due to the need to rapidly
increase deposit rates.  The decline in net income in the rising rate
environment is a result of our conservative evaluation of the market pressure to
increase rates on deposits, which causes a decline in the net interest
margin.
 
 The
following table sets forth the dollar amounts of maturing and/or repricing
assets and liabilities for various periods. This does not include the impact of
prepayments or other forms of convexity caused by changing interest rates.
Historically, this has been immaterial and estimates for them are not
included.
 
 47
 We have
more liabilities than assets repricing during the next year. Usually because our
asset rates change more than deposit rates, our interest income will change more
than the cost of funds when rates change.  For the current quarter, we
are making a more conservative assumption.  Historically, we have been
able to raise deposit rates with a lag to loan rate increases, however market
demands are creating pressure to raise interest rates on deposits in the event
of a rise in interest rates.  Therefore for a period of time we have
chosen to use the simulation to forecast deposits rates rising quite
rapidly.  This causes the net interest margin to shrink and net
interest income to decline in both a rising and falling rate
environment.  The table below indicates that we are liability
sensitive throughout the next year.  At the end of the twelve month
cycle, the rate sensitive gap shows $68.4 million more in liabilities than
assets with a repricing opportunity.
 
 We
control long-term interest rate risk by keeping long term fixed rate assets
(longer than 5 years) less than its long term fixed rate funding, primarily
demand deposit accounts and capital. The following table sets forth cumulative
maturity distributions as of December 31, 2008 for our interest-bearing assets
and interest-bearing liabilities, and our interest rate sensitivity gap as a
percentage of total interest-earning assets.  Of the $130.4 million in
fixed rate assets repricing in the over 12 months category, shown in the table
below, $37.3million are long term
assets with a maturity over five years.  This $37.3 million compares
favorably to our long term funding of $78.7 million which includes demand and
core deposits and equity.
  (dollars
in thousands)





Immediate
              
              
              Up
      to 3
              
              
              4
      to 6
              
              
              7
      to 12
              
              
              OverDecember
      31, 2008
              
              Reprice
              
              
              Months
              
              
              Months
              
              
              Months
              
              
              12 Months
              
              
              TotalASSETS:Securities
      + Other Interest-Bearing Balances
              
              $
              0
              
              
              $
              0
              
              
              $
              2,472
              
              
              $
              4,945
              
              
              $
              13,025
              
              
              $
              20,442Loans
              
              
              64,760
              
              
              
              10,355
              
              
              
              24,399
              
              
              
              45,458
              
              
              
              117,405
              
              
              
              262,377Fed
      Funds Sold + Overnight
                Interest-Bearing
      Balances
              
              
              274
              
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              
              0
              
              
              
              274Total
      Rate Sensitive Assets
              
              $
              65,034
              
              
              $
              10,355
              
              
              $
              26,871
              
              
              $
              50,403
              
              
              $
              130,430
              
              
              $
              283,093LIABILITIES:MMDA/NOW/SAV
              
              $
              119,380
              
              
              $
              0
              
              
              $
              0
              
              
              $
              0
              
              
              $
              0
              
              
              $
              119,380CD’s<$100
              
              
              0
              
              
              
              11,873
              
              
              
              9,894
              
              
              
              9,894
              
              
              
              3,674
              
              
              
              35,335CD’s>$100
              
              
              0
              
              
              
              12,507
              
              
              
              26,049
              
              
              
              6,512
              
              
              
              5,883
              
              
              
              50,951Borrowings
              
              
              0
              
              
              
              10,000
              
              
              
              0
              
              
              
              15,000
              
              
              
              5,000
              
              
              
              30,000Total
      Rate Sensitive Liabilities
              
              $
              119,380
              
              
              $
              34,380
              
              
              $
              35,943
              
              
              $
              31,406
              
              
              $
              14,557
              
              
              $
              235,666Rate
      Sensitivity Gap
              
              $
              (54,346
              )
              
              $
              (24,025
              )
              
              $
              (9,072
              )
              
              $
              18,997
              
              
              $
              115,873
              
              
              $
              47,427Cumulative
      Rate Sensitivity Gap
              
              $
              (54,346
              )
              
              $
              (78,371
              )
              
              $
              (87,443
              )
              
              $
              (68,446
              )
              
              $
              47,427Cumulative
      Position to Total Assets
              
              
              (16.9
              %)
              
              
              (24.4
              %)
              
              
              (27.2
              %)
              
              
              (21.3
              %)
              
              
              14.7
              %


Market risk in
securities.Market
risk in securities shows the amount of gain or loss (before tax) in the
securities portfolio.  Portfolio volume, sector distribution,
duration, and quality all affect market valuation.  The adjusted
equity ratio is Tier 1 capital adjusted for the market gain or loss less any
applicable tax effect divided by average total assets for leverage capital
purposes for the most recent quarter.
  48
 The
ratio is designed to show Tier 1 capital if the securities portfolio had to be
liquidated and all gains and losses recognized.  If the ratio remains
strong after a +2% or +3% rate shock, market risk is reasonable in relation to
the level of capital.  A bank has flexibility and strength when the
securities portfolio can be liquidated for liquidity purposes without affecting
capital adequacy.
  We
have only moderate market risk in investments because the average maturity in
the portfolio is not very long, except for municipals, which are held to
maturity (see page 40for
a discussion of investments).  The portfolio should decline in value
only about 0.8% or $348,000 for a 1% increase in rates.  The gain in
value if rates fall would be somewhat less, because there are some callable
bonds.  Marking-to-market available for sale securities when rates
change would add only modest volatility to a strong level of
equity.  This market risk acts to offset the interest rate risk (i.e.
if rates decline and NIM is squeezed, there would be a concurrent gain in the
value of securities).
  Inflation
  Assets
and liabilities of a financial institution are principally monetary in
nature.  Accordingly, interest rates, which generally move with the
rate of inflation, have potentially the most significant effect on our net
interest income.  We attempt to limit inflation's impact on rates and
net income margins by minimizing its effect on these margins through continuing
asset/liability management programs.




Management's
Discussion and Analysis
 The
Year Ended December 31, 2007 versus December 31, 2006
 
 Summary
 
 Net
income for 2007 was $4,343,538 compared with $3,991,759 million in
2006.  Basic earnings per share for 2007 were $1.94 compared with
$1.78 in 2006.  Return on average assets was 1.52% in both 2007 and
2006, while return on average equity was 15.94% in 2007 and 15.90% for the
previous year.
  Total
assets reached $297.9 million in 2007, a 7.3% increase over the $277.7 million
at December 31, 2006.  We showed loans of $250.5 million in 2007,
compared with $219.6 million at year-end 2006, an increase of
14.0%.  Deposits increased, growing 1.4%, from $232.8 million at
year-end 2006 to $236.0 million at year-end 2007.  The loan-to-deposit
ratio increased to 106.1% in 2007 from 94.3% in 2006.
  Net
Interest Income
  Net
interest income, adjusted to a fully taxable equivalent basis, increased $1.4
million to $14.7 million in 2007, up 11.0% from $13.3 million in
2006.  Our net interest margin was 5.51% in 2007 compared to 5.46% in
2006.
  Individual
components of interest income and interest expense are provided in the table -
Average Balances, Yields and Rates Paid on page 35.
  Interest
Income
  Interest
income increased by $3.4 million, or 19.4%, to $21.2 million over the $17.8
million realized in 2006.  The gain in volume of average earning
assets was responsible for a $2.660 million increase in interest income, while
the increase in yield contributed $781,000 for a total increase of $3.441
million.
  49
 Interest
Expense
  Total
interest expense increased $2.0 million to $6.4 million.  The average
rate paid on all interest-bearing liabilities was 3.22% in 2007, compared to
2.51% in 2006.  Average balances increased from $177.5 million to
$199.6 million, a 12.4% gain.
  The
gain in volume of average balances was responsible for a $1.127 million increase
in interest expense in conjunction with a $851,000 increase related to higher
interest rates paid for a net increase of $1.978 million.  The higher
rates paid on interest-bearing liabilities was a result of market pressures
driving interest rates paid on deposit accounts higher.
  Individual
components of interest income and interest expense are provided in the table –
Average Balances, Yields and Rates Paid on page 35.




Provision
for Loan Losses
 
 The
provisions to the allowance for loan losses amounted to $680,000 in 2007 and
$500,000 in 2006. The increase in the provision is the result of management’s
evaluation and assessment of the loan portfolio and the growth in the loan
portfolio.
  The
non-performing assets ratio at December 31, 2007 was .45% compared to .42% as of
year end 2006.  Non accrual loans were $800,000 as of December 31,
2007 compared to $820,000 as of December 31, 2006, a decline of
2.4%.   Loans charged-off, net of recoveries, resulted in net
losses of $234,000 in 2007 and in net recoveries totaling $465 in 2006. Refer to
page 70, Note D for an analysis of the changes in the allowance for loan and
lease losses.
  Non-interest
Income
  Non-interest
income of $2.3 million for 2007 increased 8.8% or $185,000 compared to the $2.1
million recorded in 2006.  Of the increase 43.5% or $81,000 was due to
an increase in all other non-interest income, 31.6% was a result of increases in
service charges on deposit account of $58,000 and the remainder of the increase
was in the area of other fee income, an increase of $46,000 or
24.9%.  All other non-interest income showed a 22.3% increase or
$81,000 from $361,000 in 2006 to $442,000 in 2007.  This is largely a
result of an increase in the income generated by bank owned life insurance
policies in 2007.  Income on the policies was $417,000 in 2007
compared to $348,000 in 2006 or yields of 4.14% and 3.73%, respectively. The
earnings on these policies will increase as the balances increase and if market
rates increase, the income produced by these policies should also increase.
Additionally, there was an $11,600 increase in check printing income due to a
change in vendors.
  Other
fee income showed an increase in 2007 of 12.4% or $46,000 from $380,000 in 2006
to $426,000 in 2007.  The higher income is a result of an increase of
$24,000 in income we earned from loan referrals, which increased from $56,000 in
2006 to $80,000 in 2007.  Also contributing to the increase was an
increase of $11,000 in credit card merchant fee income from $162,000 in 2006 to
$173,000 in 2007.
  50
 Non-interest
Expense
  Total
non-interest expense increased 10.6% to $9.2 million in 2007 from $8.3 million
in 2006.  Non-interest expense represented 3.20% of average total
assets in 2007 and 3.17% in 2006. The expense/asset ratio is a standard industry
measurement of a bank's ability to control its overhead or non-interest costs.
During 2008, we will continue to emphasize cost controls, although certain
costs, such as costs of company insurance and certain salary and benefit
expenses such as workers compensation insurance and medical benefits are not
controllable by management.  We monitor our efficiency ratio relative
to peers as a means of evaluating out control over expenses. The efficiency
ratio is operating expenses divided by revenues (net interest income plus
non-interest income). This ratio has become an industry “benchmark” and is used
as a means of measuring overall expense management. For example, an efficiency
ratio of 60% indicates that a bank spends $0.60 to generate $1.00 of revenues.
As of December 31, 2007 and December 31, 2006 our efficiency ratios were 53.88%
and 53.95%, respectively. Refer to Note I, page 75 for a detailed
description of Non-Interest Income and Other Non-Interest
Expense.




Salaries
and Benefits 
 The
most significant dollar increase was in the salaries and benefits
category.  Salary and benefits increased 13.1% from $4.9 million in
2006 to $5.5 million in 2007. The increase is a result of an increase of
$357,000 in salary expense which grew from $2.9 million in 2006 to $3.3 million
in 2007. At December 31, 2007 and December 31, 2006 total full time equivalent
employees were 51 and 49, respectively an increase of two full time equivalent
employees. Also contributing to the increase is normal merit increases. Year-end
assets per employee were $5.8 million in 2007 compared with $5.7 million in
2006.  Additionally, accrual adjustments were necessary to the
Supplemental Executive retirement plan.   An additional increase
in expense of $81,000 over prior year was taken for restricted stock that was
granted to bank officers.
  Premises
and Equipment
  Expense
relative to premises and equipment decreased 5.7% to $959,000 in 2007 from
$1.016 million in 2006.  Most areas of premises and equipment
showed declines except for lease expense.  Lease expense increased
from $364,000 in 2006 to $381,000 in 2007, a $17,000 (4.64%)
increase.  The Bank continues to emphasize security in its computer
operations.  Equipment and software are monitored and upgraded as
appropriate to ensure confidentiality of customer and Company data contributing
to additional increases in expense.  We continue to emphasize the
utilization of technology to accommodate customer and market
demands.
  Other
Non-interest Expense
  Other
non-interest expense showed an increase of 12.2% or $286,000 to $2.6 million in
2007 from $2.3 million in 2006.  The largest piece of this increase
was due to increases in professional fees.  Professional fees were
$702,000 in 2006 and increased to $1.0 million in 2007, an increase of
$316,000.  The categories of professional fees which showed the most
significant increases were in the areas of accounting and taxes, legal
fees-corporate matters, other professional fees, other exam fees and director
fees.  Other professional grew significantly due to the involvement of
an outside technology company to assist with network security and disaster
planning.
  51
 Expense
for advertising and marketing increased $10,000 from $276,000 in 2006 to
$286,000 in 2007.  The increases in this category are a result of our
involvement in the community, both through donations as well as participation in
civic organizations.  Additionally, shareholder relations showed an
increase in 2007 over 2006.
  Provision
for Income Taxes
  The
provision for income taxes increased to an effective tax rate of 36% in 2007
compared with 35.7% in 2006.  The higher effective tax rate is a
reflection of the increase in taxable income when compared with income derived
from tax exempt investments.  Income taxes reported in the financial
statements include deferred taxes resulting from timing differences in the
recognition of items for tax and financial reporting purposes.
  ITEM
7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK
  Information
regarding Quantitative and Qualitative Disclosures about Market Risk appears on
pages 46through
49 under the caption “Management’s Discussion and Analysis of Consolidated
Financial Condition and Results of Operations – Market Risk Management” and is
incorporated herein by reference.


52









































SONOMA
VALLEY BANCORP AND SUBSIDIARY





Audited
Consolidated Financial Statements





December
31, 2008














































53







Richardson &
Company





550 Howe
Avenue, Suite 210


Sacramento,
California 95825


Telephone:
(916) 564-8727


FAX:
(916) 564-8728




REPORT OF
RICHARDSON & COMPANY


INDEPENDENT
REGISTERED PUBLIC


ACCOUNTING
FIRM






Board of
Directors and Shareholders


Sonoma
Valley Bancorp and Subsidiary


Sonoma,
California






We have
audited the accompanying consolidated balance sheets of Sonoma Valley Bancorp
and Subsidiary as of December 31, 2008 and 2007, and the related consolidated
statements of operations, changes in  shareholders' equity and cash
flows for each of the three years in the period ended December 31,
2008.  These financial statements are the responsibility of the
Company’s management.  Our responsibility is to express an opinion on
these financial statements based on our audits.




We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement.  The
company is not required to have, nor were we engaged to perform, an audit of its
internal control over financial reporting.  Our audit included
consideration of internal control over financial reporting as a basis of
designing audit procedures that are appropriate in the circumstances, but not
for the purpose of expressing an opinion on the effectiveness of the company’s
internal control over financial reporting.  Accordingly, we express no
such opinion.  An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial
statements.  An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation.  We believe
that our audits provide a reasonable basis for our opinion.




In our
opinion, the financial statements referred to above present fairly, in all
material respects, the consolidated financial position of Sonoma Valley Bancorp
and Subsidiary as of December 31, 2008 and 2007, and the consolidated results of
their operations and their consolidated cash flows for each of the three years
in the period ended December 31, 2008, in conformity with accounting principles
generally accepted in the United States of America.





March 5,
2009


54


SONOMA
VALLEY BANCORP AND SUBSIDIARY





CONSOLIDATED
BALANCE SHEETS


December
31, 2008 and 2007


ASSETS
              
              2008
              
              
              2007Cash
      and due from banks
              
              $
              17,959,020
              
              
              $
              6,268,091Interest-bearing
      due from banks
              
              
              274,035
              
              
              
              3,065,543Total
      cash and cash equivalents
              
              
              18,233,055
              
              
              
              9,333,634Investment
      securities available-for-sale, at fair value
              
              
              6,578,924
              
              
              
              8,203,190Investment
      securities held-to-maturity (fair value
                of
      $14,028,111 and $14,754,249, respectively)
              
              
              13,862,911
              
              
              
              14,554,224Loans
      and lease financing receivables, net
              
              
              262,376,784
              
              
              
              246,738,218Premises
      and equipment, net
              
              
              734,091
              
              
              
              792,455Accrued
      interest receivable
              
              
              1,678,547
              
              
              
              1,682,209Cash
      surrender value of life insurance
              
              
              10,777,482
              
              
              
              10,354,153Other
      assets
              
              
              7,706,287
              
              
              
              6,201,195Total
      assets
              
              $
              321,948,081
              
              
              $
              297,859,278LIABILITIESNoninterest-bearing
      demand deposits
              
              $
              48,279,759
              
              
              $
              58,589,202Interest-bearing
      transaction deposits
              
              
              31,062,597
              
              
              
              30,135,049Savings
      and money market deposits
              
              
              88,317,397
              
              
              
              73,528,081Time
      deposits, $100,000 and over
              
              
              50,694,468
              
              
              
              44,160,741Other
      time deposits
              
              
              35,591,280
              
              
              
              29,634,626Total
      deposits
              
              
              253,945,501
              
              
              
              236,047,699Federal
      Home Loan Bank borrowings
                Accrued
      interest payable  and other liabilities
              
              
              30,000,000
      7,142,484
              
              
              
              27,500,000
      6,377,299Total
      liabilities
              
              
              291,087,985
              
              
              
              269,924,998Commitments
      and contingencies ( see accompanying notes )SHAREHOLDERS’
      EQUITYCommon
      stock, no par value; 10,000,000 shares
                authorized;
      2,290,657 shares in 2008 and 2,242,809 in
                2007
      issued and outstanding
              
              
              16,402,084
              
              
              
              15,578,903Additional
      paid-in-capital
                Retained
      earnings
              
              
              2,577,855
      11,863,688
              
              
              
              2,455,409
      9,934,967Accumulated
      other comprehensive income/(loss)
              
              
              16,469
              
              
              
              (34,999
              )Total
      liabilities and shareholders’ equity
              
              $
              321,948,081
              
              
              $
              297,859,278





The
accompanying notes are an integral part of these financial
statements.


55




SONOMA
VALLEY BANCORP AND SUBSIDIARY





CONSOLIDATED
STATEMENTS OF OPERATIONS





For the
years ended December 31, 2008, 2007 and 2006





2008
                
                2007
                2006INTEREST
      INCOMELoans
      and leases
                
                $
                19,125,311
                
                
                $
                19,592,855
                
                $
                15,778,313Taxable
      securities
                
                
                136,519
                
                
                
                459,978
                
                
                864,410Tax-exempt
      securities
                
                
                530,526
                
                
                
                646,920
                
                
                607,276Federal
      funds sold and other
                
                
                49,931
                
                
                
                33,352
                
                
                79,079Dividends
                
                
                88,602
                
                
                
                70,517
                
                
                51,062Total
      interest income
                
                
                19,930,889
                
                
                
                20,803,622
                
                
                17,380,140INTEREST
      EXPENSEInterest-bearing
      transaction deposits
                
                
                49,514
                
                
                
                47,332
                
                
                50,928Savings
      and money market deposits
                
                
                1,433,907
                
                
                
                1,887,350
                
                
                1,363,563Time
      deposits, $100,000 and over
                  Other
      time deposits
                
                
                1,933,523
      1,138,555
                
                
                
                1,957,123
      1,300,629
                
                
                1,602,820
      1,015,391Interest
      on borrowings
                
                
                892,122
                
                
                
                1,244,256
                
                
                425,681Total
      interest expense
                
                
                5,447,621
                
                
                
                6,436,690
                
                
                4,458,383NET
      INTEREST INCOME
                
                
                14,483,268
                
                
                
                14,366,932
                
                
                12,921,757Provision
      for loan and lease losses
                
                
                2,110,000
                
                
                
                680,000
                
                
                500,000NET
      INTEREST INCOME AFTER PROVISION
                  FOR
      LOAN AND LEASE LOSSES
                
                
                12,373,268
                
                
                
                13,686,932
                
                
                12,421,757NON-INTEREST
      INCOME
                
                
                2,131,182
                
                
                
                2,278,810
                
                
                2,093,738NON-INTEREST
      EXPENSESalaries
      and employee benefits
                
                
                5,610,821
                
                
                
                5,587,176
                
                
                4,940,130Premises
      and equipment
                
                
                936,798
                
                
                
                959,021
                
                
                1,016,200Other
                
                
                3,076,292
                
                
                
                2,635,845
                
                
                2,349,639Total
      non-interest expense
                
                
                9,623,911
                
                
                
                9,182,042
                
                
                8,305,969Income
      before provision for income taxes
                
                
                4,880,539
                
                
                
                6,783,700
                
                
                6,209,526Provision
      for income taxes
                
                
                1,565,178
                
                
                
                2,440,162
                
                
                2,217,767NET
      INCOME
                
                $
                3,315,361
                
                
                $
                4,343,538
                
                $
                3,991,759BASIC
      EARNINGS PER SHARE
                
                $
                1.46
                
                
                $
                1.94
                
                $
                1.78DILUTED
      EARNINGS PER SHARE
                
                $
                1.45
                
                
                $
                1.88
                
                $
                1.68




The
accompanying notes are an integral part of these financial
statements.




56


SONOMA
VALLEY BANCORP AND SUBSIDIARY




CONSOLIDATED
STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY





For the
years ended December 31, 2008, 2007 and 2006




AccumulatedAdditional
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      OtherComprehensive
                                                                      
                                                                      
                                                                      Common
      Stock
                                                                      
                                                                      
                                                                      Paid-in
                                                                      
                                                                      
                                                                      Retained
                                                                      
                                                                      
                                                                      ComprehensiveIncome
                                                                      
                                                                      
                                                                      Shares
                                                                      
                                                                      
                                                                      Amount
                                                                      
                                                                      
                                                                      Capital
                                                                      
                                                                      
                                                                      Earnings
                                                                      
                                                                      
                                                                      Income
      (Loss)
                                                                      
                                                                      
                                                                      TotalBALANCE
      AT
                                                                        JANUARY
      1, 2006
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      2,204,949
                                                                      
                                                                      
                                                                      $
                                                                      15,004,135
                                                                      
                                                                      
                                                                      $
                                                                      1,252,292
                                                                      
                                                                      
                                                                      $
                                                                      7,493,757
                                                                      
                                                                      
                                                                      $
                                                                      (310,391
                                                                      )
                                                                      
                                                                      $
                                                                      23,439,793Redemption
      and
                                                                        retirement
      of stock
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      (55,028
                                                                      )
                                                                      
                                                                      
                                                                      (410,308
                                                                      )
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      (1,025,843
                                                                      )
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      (1,436,151
                                                                      )Stock
      options exercised
                                                                        and
      related tax benefits
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      104,126
                                                                      
                                                                      
                                                                      
                                                                      885,729
                                                                      
                                                                      
                                                                      
                                                                      438,757
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      1,324,486Cash
      dividends of $.55 per share
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      (1,252,957
                                                                      )
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      (1,252,957
                                                                      )Stock
      options vested
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      100,224
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      100,224Restricted
      stock granted
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      29,000
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      81,375
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      81,375Net
      income for the year
                                                                      
                                                                      $
                                                                      3,991,759
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      3,991,759
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      3,991,759Other
      comprehensive
                                                                        income,
      net of tax:
                                                                        Unrealized
      holding
                                                                        gains
      on securities
                                                                        available-for-sale
                                                                        arising
      during the year,
                                                                        net
      of taxes of $108,781
                                                                      
                                                                      
                                                                      155,542Other
      comprehensive
                                                                        income,
      net of taxes
                                                                      
                                                                      
                                                                      155,542
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      155,542
                                                                      
                                                                      
                                                                      
                                                                      155,542Total
      comprehensive
                                                                        income
                                                                      
                                                                      $
                                                                      4,147,301BALANCE
      AT
                                                                        DECEMBER
      31, 2006
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      2,283,047
                                                                      
                                                                      
                                                                      
                                                                      15,479,556
                                                                      
                                                                      
                                                                      
                                                                      1,872,648
                                                                      
                                                                      
                                                                      
                                                                      9,206,716
                                                                      
                                                                      
                                                                      
                                                                      (154,849
                                                                      )
                                                                      
                                                                      
                                                                      26,404,071Redemption
      and

                                                                        retirement
      of stock
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      (100,415
                                                                      )
                                                                      
                                                                      
                                                                      (689,422
                                                                      )
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      (2,243,816
                                                                      )
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      (2,933,238
                                                                      )Stock
      options exercised

                                                                        and
      related taxbenefits
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      60,177
                                                                      
                                                                      
                                                                      
                                                                      626,019
                                                                      
                                                                      
                                                                      
                                                                      358,353
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      984,372Cash
      dividends of $.60 per share
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      (1,371,471
                                                                      )
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      (1,371,471
                                                                      )Stock
      options vested
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      216,473
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      216,473Restricted
      stock vested

                                                                        and
      related tax benefits
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      162,750
                                                                      
                                                                      
                                                                      
                                                                      7,935
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      170,685Net
      income for the year
                                                                      
                                                                      $
                                                                      4,343,538
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      4,343,538
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      4,343,538Other
      comprehensive
                                                                        income, net of
      tax:
                                                                        Unrealized
      holding
                                                                        gains on
      securities
                                                                        available-for-sale
                                                                        arising during
      the year,
                                                                        net of taxes
      of $83,819
                                                                      
                                                                      
                                                                      119,850Other
      comprehensive
                                                                        income, net of
      taxes
                                                                      
                                                                      
                                                                      119,850
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      119,850
                                                                      
                                                                      
                                                                      
                                                                      119,850Total
      comprehensive
                                                                        income
                                                                      
                                                                      $
                                                                      4,463,388BALANCE
      AT
                                                                        DECEMBER 31,
      2007
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      2,242,809
                                                                      
                                                                      
                                                                      
                                                                      15,578,903
                                                                      
                                                                      
                                                                      
                                                                      2,455,409
                                                                      
                                                                      
                                                                      
                                                                      9,934,967
                                                                      
                                                                      
                                                                      
                                                                      (34,999
                                                                      )
                                                                      
                                                                      
                                                                      27,934,280




57


SONOMA
VALLEY BANCORP AND SUBSIDIARY




CONSOLIDATED
STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY





For the
years ended December 31, 2008, 2007 and 2006






AccumulatedAdditional
                            
                            
                            
                            
                            
                            OtherComprehensive
                            
                            
                            Common
      Stock
                            
                            
                            Paid-in
                            
                            
                            Retained
                            
                            
                            ComprehensiveIncome
                            
                            
                            Shares
                            
                            
                            Amount
                            
                            
                            Capital
                            
                            
                            Earnings
                            
                            
                            Income
      (Loss)
                            
                            
                            TotalRedemption
      and
                              retirement
      of stock
                            
                            
                            
                            
                            
                            (1,190
                            )
                            
                            $
                            (8,526
                            )
                            
                            
                            
                            
                            
                            $
                            (13,414
                            )
                            
                            
                            
                            
                            
                            $
                            (21,940
                            )Stock
      options exercised
                              and
      related tax benefits
                            
                            
                            
                            
                            
                            49,038
                            
                            
                            
                            668,957
                            
                            
                            
                            72,318
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            741,275Cash
      dividends of $.60 per share
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            (1,373,226
                            )
                            
                            
                            
                            
                            
                            
                            (1,373,226
                            )Stock
      options vested
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            64,805
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            64,805Restricted
      stock vested
                              and
      related tax benefits
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            162,750
                            
                            
                            
                            (14,677
                            )
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            148,073Net
      income for the year
                            
                            $
                            3,315,361
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            3,315,361
                            
                            
                            
                            
                            
                            
                            
                            3,315,361Other
      comprehensive
                              income,
      net of tax:
                              Unrealized
      holding
                              gains
      on securities
                              available-for-sale
                              arising
      during the year,
                              net
      of taxes of $35,994
                            
                            
                            51,468Other
      comprehensive
                              income,
      net of taxes
                            
                            
                            51,468
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            51,468
                            
                            
                            
                            51,468Total
      comprehensive
                              income
                            
                            $
                            3,366,829BALANCE
      AT
                              DECEMBER
      31, 2008
                            
                            
                            
                            
                            
                            
                            2,290,657
                            
                            
                            $
                            16,402,084
                            
                            
                            $
                            2,577,855
                            
                            
                            $
                            11,863,688
                            
                            
                            $
                            16,469
                            
                            
                            $
                            30,860,096






The
accompanying notes are an integral part of these financial
statements.




58


SONOMA
VALLEY BANCORP AND SUBSIDIARY





CONSOLIDATED
STATEMENTS OF CASH FLOWS





For the
years ended December 31, 2008, 2007 and 2006








2008
                                          
                                          
                                          2007
                                          
                                          
                                          2006OPERATING
      ACTIVITIESNet
      income
                                          
                                          $
                                          3,315,361
                                          
                                          
                                          $
                                          4,343,538
                                          
                                          
                                          $
                                          3,991,759Adjustments
      to reconcile net income
                                            to
      net cash provided by operating activities:Provision
      for loan and lease losses
                                          
                                          
                                          2,110,000
                                          
                                          
                                          
                                          680,000
                                          
                                          
                                          
                                          500,000Depreciation
                                          
                                          
                                          229,538
                                          
                                          
                                          
                                          239,374
                                          
                                          
                                          
                                          284,357Gain
      on sale of equipment
                                          
                                          
                                          45Amortization and other
                                          
                                          
                                          71,590
                                          
                                          
                                          
                                          40,254
                                          
                                          
                                          
                                          116,041Stock
      options and restricted stock granted
                                          
                                          
                                          227,555
                                          
                                          
                                          
                                          379,223
                                          
                                          
                                          
                                          181,599Provision
      for foreclosed real estate
                                          
                                          
                                          34,751Net
      change in interest receivable
                                          
                                          
                                          3,662
                                          
                                          
                                          
                                          (10,591
                                          )
                                          
                                          
                                          (271,363
                                          )Net
      change in cash surrender value
                                            of
      life insurance
                                          
                                          
                                          (423,329
                                          )
                                          
                                          
                                          (416,847
                                          )
                                          
                                          
                                          (347,867
                                          )Net
      change in other assets
                                          
                                          
                                          (1,111,380
                                          )
                                          
                                          
                                          (1,002,003
                                          )
                                          
                                          
                                          (185,303
                                          )Net
      change in interest payable
                                            and
      other liabilities
                                          
                                          
                                          765,185
                                          
                                          
                                          
                                          494,851
                                          
                                          
                                          
                                          1,018,091NET
      CASH PROVIDED BY
                                            OPERATING
      ACTIVITIES
                                          
                                          
                                          5,222,978
                                          
                                          
                                          
                                          4,747,799
                                          
                                          
                                          
                                          5,287,314INVESTING
      ACTIVITIESPurchases
      of securities held-to-maturity
                                          
                                          
                                          (495,000
                                          )
                                          
                                          
                                          (101,751
                                          )
                                          
                                          
                                          (438,272
                                          )Purchases
      of securities available-for-sale
                                          
                                          
                                          (6,506,649
                                          )
                                          
                                          
                                          (4,195
                                          )
                                          
                                          
                                          (42,140
                                          )Proceeds
      from maturing securities held-to-maturity
                                          
                                          
                                          1,128,100
                                          
                                          
                                          
                                          1,307,600
                                          
                                          
                                          
                                          1,055,000Proceeds
      from maturing securities available-for-sale
                                          
                                          
                                          8,205,000
                                          
                                          
                                          
                                          13,000,000
                                          
                                          
                                          
                                          13,195,000Net increase in loans and leases
                                          
                                          
                                          (18,068,982
                                          )
                                          
                                          
                                          (31,087,528
                                          )
                                          
                                          
                                          (48,412,605
                                          )Purchases of premises and equipment
                                          
                                          
                                          (171,219
                                          )
                                          
                                          
                                          (82,605
                                          )
                                          
                                          
                                          (54,915
                                          )Purchases
      of life insurance
                                          
                                          
                                          0
                                          
                                          
                                          
                                          (350,000
                                          )
                                          
                                          
                                          0Proceeds
      from disposal of equipment
                                          
                                          
                                          0
                                          
                                          
                                          
                                          0
                                          
                                          
                                          
                                          0NET
      CASH USED FOR
                                            INVESTING
      ACTIVITIES
                                          
                                          
                                          (15,908,750
                                          )
                                          
                                          
                                          (17,318,479
                                          )
                                          
                                          
                                          (34,697,932
                                          )





(Continued)


59


SONOMA
VALLEY BANCORP AND SUBSIDIARY





CONSOLIDATED
STATEMENTS OF CASH FLOWS (Continued)





For the
years ended December 31, 2008, 2007 and 2006








2008
                    
                    
                    2007
                    
                    
                    2006FINANCING
      ACTIVITIESNet
      change in demand, interest-bearing
                      transaction
      and savings deposits
                    
                    $
                    5,407,421
                    
                    
                    $
                    1,182,153
                    
                    
                    $
                    1,805,126Net
      change in time deposits
                    
                    
                    12,490,381
                    
                    
                    
                    2,098,131
                    
                    
                    
                    15,203,522Stock
      repurchases
                    
                    
                    (21,940
                    )
                    
                    
                    (2,933,237
                    )
                    
                    
                    (1,436,151
                    )Stock
      options exercised
                    
                    
                    582,557
                    
                    
                    
                    576,482
                    
                    
                    
                    864,993Proceeds
      from FHLB borrowings
                    
                    
                    25,000,000
                    
                    
                    
                    14,900,000
                    
                    
                    
                    12,600,000Repayments
      on FHLB borrowings
                    
                    
                    (22,500,000
                    )Cash
      dividends paid
                    
                    
                    (1,373,226
                    )
                    
                    
                    (1,371,471
                    )
                    
                    
                    (1,252,957
                    ).NET
      CASH PROVIDED BY
                      FINANCING
      ACTIVITIES
                    
                    
                    19,585,193
                    
                    
                    
                    14,452,058
                    
                    
                    
                    27,784,533NET
      CHANGE IN CASH AND CASH
                      EQUIVALENTS
                    
                    
                    8,899,421
                    
                    
                    
                    1,881,378
                    
                    
                    
                    (1,626,085
                    )Cash
      and cash equivalents at beginning of year
                    
                    
                    9,333,634
                    
                    
                    
                    7,452,256
                    
                    
                    
                    9,078,341CASH
      AND CASH EQUIVALENTS
                      AT
      END OF YEAR
                    
                    $
                    18,233,055
                    
                    
                    $
                    9,333,634
                    
                    
                    $
                    7,452,256SUPPLEMENTAL
      DISCLOSURES OF
                      CASH
      FLOW INFORMATIONInterest
      expense
                    
                    $
                    5,485,326
                    
                    
                    $
                    6,431,217
                    
                    
                    $
                    4,404,411Income
      taxes
                    
                    $
                    2,212,156
                    
                    
                    $
                    2,265,000
                    
                    
                    $
                    2,195,000SUPPLEMENTAL
      DISCLOSURES OF
                      NONCASH
      ACTIVITIES:Loans
      transferred to other real estate owned
                    
                    $
                    332,718Net
      change in unrealized gains and losses

                      on
      securities
                    
                    $
                    87,462
                    
                    
                    $
                    203,669
                    
                    
                    $
                    264,323Net change in deferred income taxes on unrealized gains and losses on
      securities
                    
                    $
                    35,994
                    
                    
                    $
                    83,819
                    
                    
                    $
                    108,781





The
accompanying notes are an integral part of these financial
statements.


60
 NOTE
A—SIGNIFICANT ACCOUNTING POLICIES
 Business:  Sonoma
Valley Bancorp (the Company), formed in 2000, is a bank holding company whose
principal activity is the ownership and management of its wholly-owned
subsidiary, Sonoma Valley Bank.  Sonoma Valley Bank was organized in
1987 and commenced operations on June 3, 1988 as a California state-chartered
bank.  The Bank is subject to regulation, supervision and regular
examination by the State Department of Financial Institutions and Federal
Deposit Insurance Corporation.  The regulations of these agencies
govern most aspects of the Bank's business. 
 Principles of
Consolidation: The consolidated financial statements include the accounts
of the Company and the Bank.  All material inter-company accounts and
transactions have been eliminated.
 
 Nature of
Operations:  The Bank provides a variety of banking services to
individuals and businesses in its primary service area of Sonoma, California and
the immediate surrounding area.  The Bank offers depository and
lending services primarily to meet the needs of its business and professional
clientele.  These services include a variety of demand deposit,
savings and time deposit account alternatives and special merchant and business
services.  The Bank's lending activities are directed primarily
towards granting short and medium-term commercial loans, customized lines of
credit, for such purposes as operating capital, business and professional
start-ups, inventory, equipment and accounts receivable and interim construction
financing.
 
 Use of
Estimates:  The preparation of financial statements in
conformity with generally accepted accounting principles requires management to
make estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period.  Actual results could differ from those
estimates.
 
 The
determination of the adequacy of the allowance for loan losses is based on
estimates that are particularly susceptible to significant changes in the
economic environment and market conditions. In connection with the determination
of the estimated losses on loans, management obtains independent appraisals for
significant collateral. The Bank's loans are generally secured by specific items
of collateral including real property, consumer assets, and business assets.
Although the Bank has a diversified loan portfolio, a substantial portion of its
debtors' ability to honor their contracts is dependent on local economic
conditions. While management uses available information to recognize losses on
loans, further reductions in the carrying amounts of loans may be necessary
based on changes in local economic conditions. Because of these factors, it is
reasonably possible that the estimated losses on loans may change materially in
the near term. However, the amount of the change that is reasonably possible
cannot be estimated.
 
 Cash and Cash
Equivalents:  For the purposes of reporting cash flows, cash
and cash equivalents are defined as those amounts included in the balance sheet
captions "Cash and due from banks" and "Federal funds sold." Generally, federal
funds are sold or purchased for one-day periods.
 
 Investment
Securities:  Securities are classified as held-to-maturity if
the Company has both the intent and ability to hold those debt securities to
maturity regardless of changes in market conditions, liquidity needs or changes
in general economic conditions.  These securities are carried at cost
adjusted for amortization of premium and accretion of discount, computed by the
interest method over their contractual lives.
 61
 NOTE
A—SIGNIFICANT ACCOUNTING POLICIES (Continued)
  Securities
are classified as available-for-sale if the Company intends to hold those debt
securities for an indefinite period of time, but not necessarily to
maturity.  Any decision to sell a security classified as
available-for-sale would be based on various factors, including significant
movements in interest rates, changes in the maturity mix of the Company's assets
and liabilities, liquidity needs, regulatory capital considerations and other
similar factors. Securities available-for-sale are carried at fair
value.  Unrealized holding gains or losses are reported as increases
or decreases in shareholders' equity, net of the related deferred tax
effect.  Realized gains or losses, determined on the basis of the cost
of specific securities sold, are included in earnings.
 
 Loans and Lease Financing
Receivables:  Loans are stated at the amount of unpaid
principal, less the allowance for loan losses and net deferred loan
fees.  Interest on loans is accrued and credited to income based on
the principal amount outstanding.  Loan origination fees and certain
direct loan origination costs are capitalized and recognized as an adjustment of
the yield on the related loan.  However, loan origination costs in
excess of fees collected are not deferred but this treatment has an immaterial
impact on the financial statements.  Amortization of net deferred loan
fees is discontinued when the loan is placed on nonaccrual status.
 
 All of
the Company’s leases are classified and accounted for as direct financing
leases.  Under the direct financing method of accounting for leases,
the total net rentals receivable under the lease contracts, net of unearned
income, are recorded as a net investment in direct financing leases, and the
unearned income is recognized each month as it is earned so as to produce a
constant periodic rate of return on the unrecovered investment.
 
 Allowance for Loan and Lease
Losses:  The allowance is maintained at a level which, in the
opinion of management, is adequate to absorb probable losses inherent in the
loan and lease portfolio.  Management determines the adequacy of the
allowance based upon reviews of individual loans and leases, recent loss
experience, current economic conditions, the risk characteristics of the various
categories of loans and leases and other pertinent factors.  The
allowance is based on estimates, and ultimate losses may vary from the current
estimates.  These estimates are reviewed monthly and, as adjustments
become necessary, they are reported in earnings in the periods in which they
become known. Loans and leases deemed uncollectible are charged to the
allowance.  Provisions for loan and lease losses and recoveries on
loans previously charged off are added to the allowance. The allowance for loan
and lease losses is based on a formula allocation for similarly risk-rated loans
and individually for impaired loans as determined by SFAS No. 114, Accounting by Creditors for
Impairment of a Loan and SFAS No. 5, Accounting for
Contingencies.
 
 Commercial,
real estate and construction loans are considered impaired, based on current
information and events, if it is probable that the Company will be unable to
collect the scheduled payments of principal or interest when due according to
the contractual terms of the loan agreement.  Allowances on impaired
loans are established based on the present value of expected future cash flows
discounted at the loan’s historical effective interest rate or, for
collateral-dependent loans, on the fair value of the
collateral.  Consumer and other homogeneous smaller balance loans are
reviewed on a collective basis for impairment. Cash receipts on impaired loans
are used to reduce principal.
 62
 NOTE
A—SIGNIFICANT ACCOUNTING POLICIES (Continued)
  Income Recognition on
Impaired and Nonaccrual Loans and Leases:  Loans and
leases, including impaired loans, are generally classified as nonaccrual if they
are past due as to maturity or payment of principal orinterest
for a period of more than 90 days, unless such loans are well-secured and in the
process of collection. If a loan or lease or a portion of a loan or lease is
classified as doubtful or is partially charged off, the loan or lease is
classified as nonaccrual except for overdrafts that are converted to
loans.  These loans are classified as doubtful but are carried in
accrual status as long as they are current.  Loans and leases that are
on a current payment status or past due less than 90 days may also be classified
as nonaccrual if repayment in full of principal and/or interest is in
doubt. 
 Loans and
leases may be returned to accrual status when all principal and interest amounts
contractually due (including arrearages) are reasonably assured of repayment
within an acceptable period of time, and there is a sustained period of
repayment performance by the borrower, in accordance with the contractual terms
of interest and principal.
 
 While a
loan or lease is classified as nonaccrual and the future collectability of the
recorded balance is doubtful, collections of interest and principal are
generally applied as a reduction to principal outstanding.  When the
future collectability of the recorded balance is expected, interest income may
be recognized on a cash basis.  In the case where a nonaccrual loan or
lease had been partially charged off, recognition of interest on a cash basis is
limited to that which would have been recognized on the recorded balance at the
contractual interest rate.  Cash interest receipts in excess of that
amount are recorded as recoveries to the allowance for loan losses until prior
charge-offs have been fully recovered.
 
 Premises and
Equipment:  Premises and equipment are stated at cost, less
accumulated depreciation.  The provision for depreciation is computed
principally by the straight-line method over the estimated useful lives of the
related assets.  Leasehold improvements are amortized over the shorter
of their useful life or the lease term.
 
 Investments in Limited
Partnerships:  The Company owns a 3.06% interest in a limited
partnership that owns and operates affordable housing projects.  The
investment in this project serves as an element of the Company’s compliance with
the Community Reinvestment Act and the Company receives tax benefits in the form
of deductions for operating losses and tax credits.  The tax credits
may be used to reduce taxes currently payable or may be carried back one year or
forward ten years to recapture or reduce taxes.  The Company uses the
equity method of accounting for the partnership’s operating results and tax
credits are recorded in the years they became available to reduce income
taxes.
 
 Investment in Federal Home
Loan Bank Stock: As a member of the Federal Home Loan Bank (FHLB) System,
the Bank is required to maintain an investment in capital stock of the FHLB. The
investment exceeds the minimum requirement at December 31, 2008 and 2007.
The investment is stated at cost in the accompanying balance sheets and is
reported as part of other assets.
 
 Foreclosed Real
Estate:  Foreclosed real estate includes both formally
foreclosed property and in-substance foreclosed
property.  In-substance foreclosed properties are those properties for
which the Company has taken physical possession, regardless of whether formal
foreclosure proceedings have taken place.
  63
 NOTE
A—SIGNIFICANT ACCOUNTING POLICIES (Continued)
  At the
time of foreclosure, foreclosed real estate is recorded at the lower of the
carrying amount or fair value less cost to sell, which becomes the property’s
new basis.  Any write-downs based on the asset’s fair value at date of
acquisition are charged to the allowance for loan losses.  After
foreclosure, valuations are periodically
performed by management and the real estate is carried at the lower of their new
cost basis or fair value minus estimated costs to sell.  Revenue and
expenses from operations and subsequent adjustments to the carrying amount are
included in other non-interest expenses.
 Income
Taxes:  Provisions
for income taxes are based on amounts reported in the statements of operations
(after exclusion of non-taxable income such as interest on state and municipal
securities) and include deferred taxes on temporary differences in the
recognition of income and expense for tax and financial statement
purposes.  Deferred taxes are computed using the asset and liability
method.  Deferred tax assets and liabilities are recognized for the
future tax consequences attributable to differences between the financial
statement carrying amounts of assets and liabilities and their respective tax
bases.  Deferred tax assets and liabilities are measured using enacted
tax rates expected to apply to taxable income in the years in which those
temporary differences are expected to be recovered or
settled.   The effect on deferred tax assets and liabilities of a
change in tax rates is recognized in income in the period that includes the
enactment date.  Deferred tax assets are recognized for deductible
temporary differences and tax credit carryforwards, and  then a
valuation allowance is established to reduce that deferred tax asset if it is
"more likely than not" that the related tax benefits will not be
realized. 
 The
Company adopted the provisions of FIN No. 48, Accounting for Uncertainty in Income
Taxes (“FIN 48”), on January 1, 2007. FIN 48 prescribes a recognition
threshold that a tax position is required to meet before being recognized in the
financial statements and provides guidance on derecognition, measurement,
classification, interest and penalties, accounting in interim periods,
disclosure and transition issues. Pursuant to FIN 48, the Company examines its
financial statements, its income tax provision, and its federal and state income
tax returns and analyzes its tax position, including permanent and temporary
differences, as well as the major components of income and expense to determine
whether a tax benefit is more likely than not to be sustained upon examination
by tax authorities. The Company recognizes interest and penalties arising from
income tax settlements as part of its provision for income taxes.
 
 Advertising:  Advertising
costs are charged to operations in the year incurred.
 
 Net Income Per Share of
Common Stock:  Net income per share of common stock is computed
by dividing net income by the weighted average number of shares of common stock
outstanding during the year, after giving retroactive effect to stock dividends
and splits.  Net income per share—assuming dilution is computed
similar to net income per share except that the denominator is increased to
include the number of additional common shares that would have been outstanding
if the dilutive potential common shares had been issued.  Included in
the denominator is the dilutive effect of stock options and unvested restricted
stock computed under the treasury method.
 
 64
 NOTE A—SIGNIFICANT ACCOUNTING POLICIES
(Continued)
  Share-Based Payment
Accounting:  At December 31, 2008, the Company has a
stock-based employee and director compensation plan, which is described more
fully in Note L.  The Company adopted the fair value recognition
provisions of Statement of Financial Accounting Standard (SFAS) No. 123, Accounting for Stock-Based
Compensation, prospectively to all employee awards granted, modified, or
settled after January 1, 2003.  Options were granted in 2004, 2007 and
2008 under the fair value method.  Awards under the plan vest over two
to five years.  Restricted stock was granted in July 2006 that vests
over three to five years beginning July 2007.  The cost related to
share-based employee compensation is included in the determination of net income
for the years ended December 31, 2008, 2007 and 2006.
  Off-Balance-Sheet Financial
Instruments:  In the
ordinary course of business the Company has entered into off-balance-sheet
financial instruments consisting of commitments to extend credit and standby
letters of credit.  Such financial instruments are recorded in the
financial statements when they become payable.
 Operating
Segments:  Reportable segments are based on products and
services, geography, legal structure, management structure and any other manner
in which management desegregates a company for making operating decisions and
assessing performance.  The Company has determined that its business
is comprised of a single operating segment.
 
 New Accounting
Pronouncements:  In June 2008, the Financial Accounting
Standard Board (FASB) issued Staff Position No. EITF 03-6-1 that addresses
whether instruments granted in share-based payment transactions are
participation securities prior to vesting and, therefore need to be included in
the earnings
 allocation
in computing earnings per share.  This Staff Position is effective for
financial statements issued for the fiscal years beginning after December 15,
2008.
 
 In
December 2007, the FASB issued SFAS No. 141, revised, Business
Combination.  This Statement established principles and
requirements for how the acquirer recognizes and measures in its financial
statements the identifiable assets acquired, the liabilities assumed, and any
noncontrolling interest, recognizes and measures goodwill acquired in a business
combination, and discloses the nature and financial effects of the business
combination.  This Statement applies prospectively to business
combinations for which the acquisition date is on or after December 15,
2008.
 
 In
December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
Consolidated Financial Statements—an Amendment of ARB No.
51.  This Statement establishes accounting and reporting
standards
 for a
minority interest in the parent company financial statements and requires
separate identification of equity and net income in the consolidated financial
statements.  This Statement is effective for fiscal years, and interim
periods within those fiscal years, beginning on or after December 15,
2008.
 
 NOTE
B—RESTRICTIONS ON CASH AND DUE FROM BANKS
 
 Cash and
due from banks include amounts the Bank is required to maintain to meet certain
average reserve and compensating balance requirements of the Federal
Reserve.  The total requirement at December 31, 2008 and 2007 was
$654,000 and $721,000, respectively.
 65
 NOTE
C—INVESTMENT SECURITIES




The amortized cost and approximate fair
value of investment securities are summarized as follows:





Amortized
      Cost
                            
                            
                            
                            Unrealized
                              Gain
                            
                            
                            
                            Unrealized
      Losses
                            
                            
                            
                            Fair
      ValueDecember
      31, 2008:Securities
      Available-For-SaleU.S. Treasury
      securities
                            
                            $
                            498,909
                            
                            
                            
                            $
                            943
                            
                            
                            
                            
                            
                            
                            
                            $
                            499,852U.S. Government agencysecurities
                            
                            
                            6,004,588
                            
                            
                            
                            
                            57,365
                            
                            
                            
                            
                            
                            
                            
                            
                            6,061,953Equity securities
                            
                            
                            47,440
                            
                            
                            
                            
                            
                            
                            
                            
                            $
                            (30,321
                            )
                            
                            
                            
                            17,119$
                            6,550,937
                            
                            
                            
                            $
                            58,308
                            
                            
                            
                            $
                            (30,321
                            )
                            
                            
                            $
                            6,578,924Securities
      Held-to-MaturityMunicipal
    securities
                            
                            $
                            13,862,911
                            
                            
                            
                            $
                            265,339
                            
                            
                            
                            $
                            (100,139
                            )
                            
                            
                            $
                            14,028,111






Amortized
      Cost
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                Unrealized
                                                                                                                                                                                                                                  Gain
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                Unrealized
      Losses
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                Fair
      ValueDecember
      31, 2007:Securities
      Available-For-SaleU.S. Treasury
      securities
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                $
                                                                                                                                                                                                                                999,495
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                $
                                                                                                                                                                                                                                349
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                $
                                                                                                                                                                                                                                999,844U.S. Government agencysecurities
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                7,216,834
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                $
                                                                                                                                                                                                                                (45,481
                                                                                                                                                                                                                                )
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                7,171,353Equity securities
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                46,335
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                (14,342
                                                                                                                                                                                                                                )
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                31,993$
                                                                                                                                                                                                                                8,262,664
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                $
                                                                                                                                                                                                                                349
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                $
                                                                                                                                                                                                                                (59,823
                                                                                                                                                                                                                                )
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                $
                                                                                                                                                                                                                                8,203,190Securities
      Held-to-MaturityMunicipal
      securities
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                $
                                                                                                                                                                                                                                14,554,224
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                $
                                                                                                                                                                                                                                226,356
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                $
                                                                                                                                                                                                                                (26,331
                                                                                                                                                                                                                                )
                                                                                                                                                                                                                                
                                                                                                                                                                                                                                $
                                                                                                                                                                                                                                14,754,249  66
   Contractual
      maturities of investment securities at December 31, 2008 were as
      follows:
 Securities
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      SecuritiesAvailable-For-Sale
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      Held-To-MaturityAmortized
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      AmortizedCost
                                                                                                                                                                                                      
                                                                                                                                                                                                      Fair
      Value
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      Cost
                                                                                                                                                                                                      
                                                                                                                                                                                                      Fair
      ValueDue
      in one year or less
                                                                                                                                                                                                      
                                                                                                                                                                                                      $
                                                                                                                                                                                                      6,503,497
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      $
                                                                                                                                                                                                      6,561,805
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      $
                                                                                                                                                                                                      854,779
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      $
                                                                                                                                                                                                      864,523Due
      after one year through five years
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      7,109,369
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      7,242,833Due
      after five years through ten years
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      4,748,090
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      4,810,605Due
      after ten years
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      1,150,673
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      1,110,150Equity
      securities
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      47,440
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      17,119$
                                                                                                                                                                                                      6,550,937
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      $
                                                                                                                                                                                                      6,578,924
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      $
                                                                                                                                                                                                      13,862,911
                                                                                                                                                                                                      
                                                                                                                                                                                                      
                                                                                                                                                                                                      $
                                                                                                                                                                                                      14,028,111  During
2008, 2007 and 2006, the Company did not sell any securities
available-for-sale.
 
 As
of  December 31, 2008, investment securities with a carrying amount of
$7,629,270 and an approximate fair value of $7,714,451 were pledged, in
accordance with federal and state requirements, as collateral for public
deposits.  Investment securities with a carrying amount and fair value
of $6,261,894 at December 31, 2008 were pledged to meet the requirements of the
Federal Reserve and the U.S. Department of Justice.  As of December
31, 2007, investment securities with a carrying amount of $6,131,085 and an
approximate fair value of $6,247,992 were pledged, in accordance with federal
and state requirements, as collateral for public deposits.  Investment
securities with a carrying amount and fair value of $3,991,635 at December 31,
2007 were pledged to meet the requirements of the Federal Reserve and the U.S.
Department of Justice.
 67


NOTE
C—INVESTMENT SECURITIES (Continued)





The
following table shows the investments’ gross unrealized losses and fair value,
aggregated by investment category and length of time that individual securities
have been in a continuous unrealized loss position, at December 31.








2008Less
      Than 12 Months
                        
                        
                        12
      Months or GreaterFair
                        
                        
                        Unrealized
                        
                        
                        Fair
                        
                        
                        UnrealizedDescription
      of Securities
                        
                        Value
                        
                        
                        Losses
                        
                        
                        Value
                        
                        
                        LossesMunicipal
      securities
                        
                        $
                        1,411,398
                        
                        
                        $
                        100,139Equity
      securities
                        
                        
                        580
                        
                        
                        
                        525
                        
                        
                        $
                        16,539
                        
                        
                        $
                        30,316Total
      temporarily impaired securities
                        
                        $
                        1,411,978
                        
                        
                        $
                        100,664
                        
                        
                        $
                        16,539
                        
                        
                        $
                        30,316








2007Less
      Than 12 Months
                  
                  
                  12
      Months or GreaterFair
                  
                  
                  Unrealized
                  
                  
                  Fair
                  
                  
                  UnrealizedDescription
      of Securities
                  
                  Value
                  
                  
                  Losses
                  
                  
                  Value
                  
                  
                  LossesU.S.
      Government agency securities
                  
                  
                  
                  
                  
                  
                  
                  $
                  7,171,353
                  
                  
                  $
                  45,481Municipal
      securities
                  
                  $
                  101,564
                  
                  
                  $
                  63
                  
                  
                  
                  3,608,462
                  
                  
                  
                  26,268Equity
      securities
                  
                  
                  11,778
                  
                  
                  
                  4,216
                  
                  
                  
                  20,215
                  
                  
                  
                  10,126Total
      temporarily impaired securities
                  
                  $
                  113,342
                  
                  
                  $
                  4,279
                  
                  
                  $
                  10,800,030
                  
                  
                  $
                  81,875





There
were 5 municipal securities and 16 equity securities in an unrealized loss
position at December 31, 2008.  There were 7 U.S. government agency
securities, 14 municipal securities and 15 equity securities in an unrealized
loss position at December 31, 2007.  The unrealized losses on these
securities were caused by interest rate increases or, in the case of the equity
securities, market disfavor with financial institutions stock.  The
Company purchased small amounts of various bank equity securities in order to
track and analyze peer group banks and the potential loss is relatively
small.   In the case of the municipal securities, the contractual
terms of these investments do not permit the issuer to settle the securities at
a price less than the par value of the investment.  Because the
Company has the ability and intent to hold these investments until a recovery of
fair value, which may be maturity, the Company does not consider these
investments to be other-than-temporarily impaired at December 31, 2008 and
2007.


68


NOTE
D—LOANS AND LEASES AND ALLOWANCE FOR LOAN AND LEASE LOSSES





The
composition of the loan and lease portfolio was as follows at December
31:





2008
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        2007Commercial
                                                                                                        
                                                                                                        $
                                                                                                        182,975,920
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        68.4
                                                                                                        %
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        $
                                                                                                        177,989,391
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        70.9
                                                                                                        %Consumer
                                                                                                        
                                                                                                        
                                                                                                        36,549,623
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        13.7
                                                                                                        %
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        29,163,877
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        11.6
                                                                                                        %Real
      estate mortgage
                                                                                                        
                                                                                                        
                                                                                                        20,163,163
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        7.5
                                                                                                        %
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        17,946,113
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        7.2
                                                                                                        %Real
      estate construction
                                                                                                        
                                                                                                        
                                                                                                        27,918,414
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        10.4
                                                                                                        %
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        25,772,958
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        10.3
                                                                                                        %Lease
      financing receivables, net of
                                                                                                          unearned income of $6,290
      in 2007
                                                                                                        
                                                                                                        
                                                                                                        17,634
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        0.0
                                                                                                        %
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        21,665
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        0.0
                                                                                                        %267,624,754
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        100.0
                                                                                                        %
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        250,894,004
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        100.0
                                                                                                        %Deferred
      loan fees and costs,  net
                                                                                                        
                                                                                                        
                                                                                                        (215,470
                                                                                                        )
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        (432,569
                                                                                                        )Allowance
      for loan and lease losses
                                                                                                        
                                                                                                        
                                                                                                        (5,032,500
                                                                                                        )
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        (3,723,217
                                                                                                        )$
                                                                                                        262,376,784
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        
                                                                                                        $
                                                                                                        246,738,218




At
December 31, 2008, the recorded investment in loans for which impairment has
been recognized in accordance with SFAS No. 114 totaled $8,700,000 with a
corresponding valuation allowance of $1,186,000. At December 31, 2007, the
recorded investment in loans for which impairment has been recognized in
accordance with Statement No. 114 totaled $2,097,000, with a corresponding
valuation allowance of $283,000.  For the years ended December 31,
2008, 2007 and 2006, the average recorded investment in impaired loans was
approximately $5,325,000, $332,000 and $1,035,000,
respectively.  During 2008, 2007 and 2006, $334,000, $163,000 and
$8,000 of interest was received and recognized on impaired loans,
respectively.
 
 At
December 31, 2008, the Company had other nonaccrual loans totaling $1,030,000
for which impairment has not been recognized.
 
 The
Company has no commitments to loan additional funds to the borrowers of impaired
or nonaccrual loans.


69


NOTE
D—LOANS AND LEASES AND ALLOWANCE FOR LOAN AND LEASE
LOSSES  (Continued)





The
maturity and repricing distribution of the loan and lease portfolio at December
31:





2008
                                        
                                        
                                        
                                        2007Fixed
      rate loan maturitiesThree
      months or less
                                        
                                        $
                                        69,203,657
                                        
                                        
                                        
                                        $
                                        32,464,840Over
      three months to twelve months
                                        
                                        
                                        65,919,143
                                        
                                        
                                        
                                        
                                        60,965,840Over
      one year to five years
                                        
                                        
                                        80,413,259
                                        
                                        
                                        
                                        
                                        93,613,696Over
      five years
                                        
                                        
                                        31,842,236
                                        
                                        
                                        
                                        
                                        16,817,804Floating
      rate loans repricingQuarterly
      or more frequently
                                        
                                        
                                        4,886,141
                                        
                                        
                                        
                                        
                                        39,892,211Quarterly
      to annual frequency
                                        
                                        
                                        861,510
                                        
                                        
                                        
                                        
                                        311,741One
      to five years frequency
                                        
                                        
                                        8,258,927
                                        
                                        
                                        
                                        
                                        6,027,843261,384,874
                                        
                                        
                                        
                                        
                                        250,093,975Nonaccrual
      loans
                                        
                                        
                                        6,239,881
                                        
                                        
                                        
                                        
                                        800,029$
                                        267,624,754
                                        
                                        
                                        
                                        $
                                        250,894,004




An
analysis of the changes in the allowance for loan and lease losses is as follows
for the years ended December 31:





2008
                      
                      
                      
                      2007
                      
                      
                      
                      2006Beginning
      balance
                      
                      $
                      3,723,217
                      
                      
                      
                      $
                      3,276,972
                      
                      
                      
                      $
                      2,776,507Provision
      for loan and lease losses
                      
                      
                      2,110,000
                      
                      
                      
                      
                      680,000
                      
                      
                      
                      
                      500,000Loans
      charged off:Commercial
                      
                      
                      (519,318
                      )
                      
                      
                      
                      (187,075
                      )
                      
                      
                      
                      (6,593
                      )Consumer
                      
                      
                      (508,758
                      )
                      
                      
                      
                      (63,901
                      )
                      
                      
                      
                      (12,262
                      )(1,028,076
                      )
                      
                      
                      
                      (250,976
                      )
                      
                      
                      
                      (18,855
                      )Recoveries:Commercial
                      
                      
                      218,812
                      
                      
                      
                      
                      16,315
                      
                      
                      
                      
                      17,668Consumer
                      
                      
                      8,547
                      
                      
                      
                      
                      906
                      
                      
                      
                      
                      1,652227,359
                      
                      
                      
                      
                      17,221
                      
                      
                      
                      
                      19,320Ending
      balance
                      
                      $
                      5,032,500
                      
                      
                      
                      $
                      3,723,217
                      
                      
                      
                      $
                      3,276,972








70


NOTE
E—PREMISES AND EQUIPMENT





Premises
and equipment consisted of the following at December 31:





2008
                      
                      
                      
                      2007Land
                      
                      $
                      175,000
                      
                      
                      
                      $
                      175,000Building
                      
                      
                      71,943
                      
                      
                      
                      
                      71,943Building
    improvements
                      
                      
                      37,402
                      
                      
                      
                      
                      25,432Leasehold
      improvements
                      
                      
                      803,594
                      
                      
                      
                      
                      797,191Furniture, fixtures and
      equipment
                      
                      
                      2,158,554
                      
                      
                      
                      
                      2,073,2183,246,493
                      
                      
                      
                      
                      3,142,784Less: Accumulated
      depreciation
                      
                      
                      (2,512,402
                      )
                      
                      
                      
                      (2,350,329
                      )$
                      734,091
                      
                      
                      
                      $
                      792,455





NOTE
F—TIME DEPOSITS





The
maturities of time deposits at December 31, 2008 are as follows:





Maturing within one
      year
                        
                        $
                        76,730,000Maturing in one year to three
      years
                        
                        
                        7,714,000Maturing three years through five
      years
                        
                        
                        1,842,000$
                        86,286,000


71


NOTE
G—FEDERAL FUNDS CREDIT LINES AND BORROWINGS




The
Company has an agreement to borrow from the Federal Reserve by obtaining
advances to the extent of pledged collateral.  Investment securities
with a carrying value of $5,700,000 were held as collateral with the Federal
Reserve Bank.  The maximum borrowing available under the agreement was
$5,500,000 at December 31, 2008.
 
 The
Company has uncommitted federal funds lines of credit agreements with other
banks.  The maximum borrowings available under these lines totaled
$19,000,000 at December 31, 2008.  There were no borrowings
outstanding under these agreements at December 31, 2008 or 2007.
 
 The
Company pledged loans totaling $152,879,522 as collateral to secure advances
from the Federal Home Loan Bank of up to $68,450,663.  At December 31,
2008, the Company had long-term borrowings of $30,000,000. The long-term
borrowings carry a fixed interest rate on outstanding principal as follows at
December 31:


Funded
                                                  Rate
                                                  Principal
      Outstanding
                                                  Maturity9/25/2008
                                                  3.68%
                                                  5,000,000
                                                  9/25/20099/19/2008
                                                  2.99%
                                                  5,000,000
                                                  3/19/20099/18/2008
                                                  3.16%
                                                  5,000,000
                                                  9/18/20099/8/2008
                                                  3.25%
                                                  5,000,000
                                                  9/08/20107/18/2008
                                                  3.14%
                                                  5,000,000
                                                  7/20/20093/1/2007
                                                  4.92%
                                                  5,000,000
                                                  3/2/2009
 
 
 
 
 72
 NOTE
H—EMPLOYEE BENEFIT PLANS
  The
Company has a 401(k) Employee Savings Plan (the Plan) in which the Company
matches a portion of the employee's contribution each payday.  All
employees are eligible for participation following three months of
employment.  Bancorp contributions are 100% vested at all
times.  The Company made contributions totaling $136,733 in 2008,
$147,994 in 2007 and $148,691 in 2006.
 
 The
Company purchased single premium life insurance policies in connection with the
implementation of retirement plans for four key officers and for the Board of
Directors.  The policies provide protection against the adverse
financial effects from the death of a key officer and provide income to offset
expenses associated with the plans.  The officers are insured under
the policies, but the Company is the owner and beneficiary.  At
December 31, 2008 and 2007, the cash surrender value of these policies totaled
$10,777,482 and $20,354,153 respectively.
 
 The
retirement plans are unfunded and provide for the Company to pay the officers
and directors specified amounts for specified periods after retirement and allow
them to defer a portion of current compensation in exchange for the Company's
commitment to pay a deferred benefit at retirement.  If death occurs
prior to or during retirement, the Company will pay the officer's beneficiary or
estate the benefits set forth in the plans.  Deferred compensation is
vested as to the amounts deferred.  Liabilities are recorded for the
estimated present value of future salary continuation benefits and for the
amounts deferred by the officers and directors.  At December 31, 2008
and 2007, the liability recorded for the executive officer supplemental
retirement plan totaled $3,383,708 and $2,665,602 respectively.  The
amount of pension expense related to this plan for 2008 and 2007 was $745,698
and $541,824, respectively.  At December 31, 2008 and 2007, the
liability recorded for the director supplemental retirement plan totaled
$457,513 and $444,580, respectively.  The amount of pension expense
related to this plan for 2008 and 2007 was $17,931 and ($129,067),
respectively.  At December 31, 2008 and 2007, the liability recorded
for the deferred compensation plans totaled $1,750,326 and $1,583,308,
respectively.  The amount of expense related to these plans for 2008
and 2007 was $120,826 and $109,768, respectively.  The following are
the components of the accumulated benefit obligation related to the executive
officer and director supplemental retirement plans as of December
31:
  Directors
                        
                        
                        
                        Officers2008
                        
                        
                        2007
                        
                        
                        
                        2008
                        
                        
                        2007Projected
      benefit obligation
                        
                        $
                        441,099
                        
                        
                        $
                        411,282
                        
                        
                        
                        $
                        3,412,343
                        
                        
                        $
                        2,933,784Accrued
      prior service costs
                        
                        
                        16,408
                        
                        
                        
                        33,298
                        
                        
                        
                        
                        ( (28,635
                        )
                        
                        
                        (268,182
                        )Benefit
      obligation included in other
                          liabilities
                        
                        $
                        457,513
                        
                        
                        $
                        444,580
                        
                        
                        
                        $
                        3,383,708
                        
                        
                        $
                        2,665,602
  The
weighted-average discount rate used in determining the actuarial present value
of the projected benefit obligation was 6.75% for both 2008 and
2007.  Inflationary increases of 4% for 2008 and 4% for 2007 were
assumed.  The Directors projected benefit calculation includes a 2%
cost of living adjustment.  The entire accumulated benefit obligation
was not fully vested at December 31, 2008 and 2007.  Full vesting for
the Officers does not occur until the participant has been in the plan for 15
years.  The Directors only receive the benefit if they are on the
Board upon reaching age 70. The measurement dates for the benefit obligation are
December 31, 2008 and 2007.
 73
 NOTE
H—EMPLOYEE BENEFIT PLANS (Continued)
 
 SFAS No.
158 applies to this Plan and requires unamortized prior service costs be
recognized as a component of other comprehensive income.  The Plan has
a net after tax unrecognized prior service cost of $7,191 at December 31, 2008
and $138,229 at December 31, 2007.  The amounts are not deemed to be
material and are not included in other comprehensive income.
 
 The
following is a reconciliation of the beginning and ending balances of the
benefit obligation for the years ended December 31:
  Directors
                            
                            
                            Officers2008
                            
                            
                            2007
                            
                            
                            2006
                            
                            
                            2008
                            
                            
                            2007
                            
                            
                            2006Benefit
      obligation at beginning of year
                            $
                            444,580
                            
                            
                            $
                            573,647
                            
                            
                            $
                            476,001
                            
                            
                            $
                            2,665,602
                            
                            
                            $
                            2,123,778
                            
                            
                            $
                            1,701,811Net
      periodic pension cost:Service cost
                            
                            45,443
                            
                            
                            
                            54,277
                            
                            
                            
                            110,027
                            
                            
                            
                            124,840
                            
                            
                            
                            218,799
                            
                            
                            
                            195,710Interest cost on projected
      benefitobligation
                            
                            26,920
                            
                            
                            
                            23,987
                            
                            
                            
                            26,275
                            
                            
                            
                            221,134
                            
                            
                            
                            190,652
                            
                            
                            
                            159,440Amortization of prior service
      costs
                            
                            (13,258
                            )
                            
                            
                            (51,638
                            )
                            
                            
                            (38,656
                            )
                            
                            
                            399,724
                            
                            
                            
                            132,373
                            
                            
                            
                            66,817Terminations
                            
                            (41,172
                            )
                            
                            
                            (155,693
                            )Benefits
      Paid
                            
                            (5,000
                            )
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            (27,592
                            )Benefit
      obligation at end of year
                            $
                            457,513
                            
                            
                            $
                            444,580
                            
                            
                            $
                            573,647
                            
                            
                            $
                            3,383,708
                            
                            
                            $
                            2,665,602
                            
                            
                            $
                            2,123,778
 
 The
following benefit payments, which reflect expected future service, as
appropriate, are expected to be paid:
 
 Directors
                        
                        
                        
                        Officers2009
                        
                        $
                        10,200
                        
                        
                        
                        $
                        225,1092010
                        
                        
                        13,237
                        
                        
                        
                        
                        225,1092011
                        
                        
                        25,990
                        
                        
                        
                        
                        352,3862012
                        
                        
                        37,397
                        
                        
                        
                        
                        352,3862013
                        
                        
                        52,058
                        
                        
                        
                        
                        352,3862014 to 2018
                        
                        
                        343,408
                        
                        
                        
                        
                        1,761,930
  74
  NOTE
I—NON-INTEREST INCOME AND OTHER NON-INTEREST EXPENSE
 
 Non-interest
income is comprised of the following for the years ended December
31:
 
 2008
                          
                          
                          
                          2007
                          
                          
                          
                          2006Service
      charges on deposit accounts
                          
                          $
                          1,332,787
                          
                          
                          
                          $
                          1,410,637
                          
                          
                          
                          $
                          1,352,251Other
      fee income
                          
                          
                          350,304
                          
                          
                          
                          
                          426,220
                          
                          
                          
                          
                          380,070Life
      insurance earnings
                          
                          
                          423,329
                          
                          
                          
                          
                          416,847
                          
                          
                          
                          
                          347,867Other
                          
                          
                          24,762
                          
                          
                          
                          
                          25,106
                          
                          
                          
                          
                          13,550$
                          2,131,182
                          
                          
                          
                          $
                          2,278,810
                          
                          
                          
                          $
                          2,093,738
 
 Other
non-interest expense is comprised of the following for the years ended December
31:
 
 2008
                          
                          
                          
                          2007
                          
                          
                          
                          2006Professional
      and consulting fees
                          
                          $
                          1,115,868
                          
                          
                          
                          $
                          1,018,088
                          
                          
                          
                          $
                          702,221Data
      processing
                          
                          
                          517,793
                          
                          
                          
                          
                          546,924
                          
                          
                          
                          
                          501,873Stationary
      and supplies
                          
                          
                          173,696
                          
                          
                          
                          
                          132,410
                          
                          
                          
                          
                          160,468Staff
      related
                          
                          
                          185,857
                          
                          
                          
                          
                          155,430
                          
                          
                          
                          
                          164,271Advertising
      and business development
                          
                          
                          339,614
                          
                          
                          
                          
                          286,074
                          
                          
                          
                          
                          276,232Postage
      and telephone
                          
                          
                          141,359
                          
                          
                          
                          
                          133,808
                          
                          
                          
                          
                          120,096Assessments
      and insurance
                          
                          
                          264,200
                          
                          
                          
                          
                          133,154
                          
                          
                          
                          
                          142,378Other
                          
                          
                          337,905
                          
                          
                          
                          
                          229,957
                          
                          
                          
                          
                          282,100$
                          3,076,292
                          
                          
                          
                          $
                          2,635,845
                          
                          
                          
                          $
                          2,349,639
 
  75
  NOTE
J—INCOME TAXES
 
 The
provision for income taxes is comprised of the following:
 
 2008
                        
                        
                        
                        2007
                        
                        
                        
                        2006CurrentFederal
                        
                        $
                        1,685,119
                        
                        
                        
                        $
                        2,062,700
                        
                        
                        
                        $
                        2,077,673State
                        
                        
                        731,718
                        
                        
                        
                        
                        782,799
                        
                        
                        
                        
                        755,9822,416,837
                        
                        
                        
                        
                        2,845,499
                        
                        
                        
                        
                        2,833,655DeferredFederal
                        
                        
                        (627,459
                        )
                        
                        
                        
                        (331,115
                        )
                        
                        
                        
                        (507,264
                        )State
                        
                        
                        (224,200
                        )
                        
                        
                        
                        (74,222
                        )
                        
                        
                        
                        (108,624
                        )(851,658
                        )
                        
                        
                        
                        (405,337
                        )
                        
                        
                        
                        (615,888
                        )Provision
      for income taxes
                        
                        $
                        1,565,178
                        
                        
                        
                        $
                        2,440,162
                        
                        
                        
                        $
                        2,217,767
 
  The
following is a reconciliation of income taxes computed at the Federal statutory
income tax rate of 34% to the effective income tax rate used for the provision
for income taxes:
 
 2008
                      
                      
                      
                      2007
                      
                      
                      
                      2006Income
      tax at Federal statutory rate
                      
                      $
                      1,659,383
                      
                      
                      
                      $
                      2,306,458
                      
                      
                      
                      $
                      2,111,239State
      franchise tax, less Federal
                        income
      tax benefit
                      
                      
                      349,173
                      
                      
                      
                      
                      485,333
                      
                      
                      
                      
                      444,254Interest
      on municipal obligations exempt
                        from
      Federal tax
                      
                      
                      (201,082
                      )
                      
                      
                      
                      (235,525
                      )
                      
                      
                      
                      (229,226
                      )Life insurance earnings
                      
                      
                      (174,219
                      )
                      
                      
                      
                      (171,551
                      )
                      
                      
                      
                      (143,163
                      )Incentive
      stock option expense
                      
                      
                      (15,630
                      )
                      
                      
                      
                      57,616
                      
                      
                      
                      
                      41,247Meals
      and entertainment
                      
                      
                      8,053
                      
                      
                      
                      
                      6,654
                      
                      
                      
                      
                      6,888Tax
      credits
                      
                      
                      (60,509
                      )
                      
                      
                      
                      (7,922
                      )Other
      differences
                      
                      
                      9
                      
                      
                      
                      
                      (901
                      )
                      
                      
                      
                      (13,472
                      )Provision
      for income taxes
                      
                      $
                      1,565,178
                      
                      
                      
                      $
                      2,440,162
                      
                      
                      
                      $
                      2,217,767
 
 
 
 
 
 76
 NOTE
J—INCOME TAXES (Continued)
 
 The tax
effects of temporary differences that give rise to the components of the net
deferred tax asset recorded as an other asset as of December 31 were as
follows:
 
 2008
                        
                        
                        
                        2007
                        
                        
                        
                        2006Deferred
      tax assets:Nonqualified
      benefit plans
                        
                        $
                        2,301,167
                        
                        
                        
                        $
                        1,931,578
                        
                        
                        
                        $
                        1,706,099Allowance for loan
      losses
                        
                        
                        1,773,938
                        
                        
                        
                        
                        1,305,486
                        
                        
                        
                        
                        1,153,381Unrealized securities holding
      losses
                        
                        
                        -
                        
                        
                        
                        
                        24,477
                        
                        
                        
                        
                        108,295Accrued
    liabilities
                        
                        
                        291,632
                        
                        
                        
                        
                        290,976
                        
                        
                        
                        
                        240,490State franchise
      taxes
                        
                        
                        235,884
                        
                        
                        
                        
                        228,912
                        
                        
                        
                        
                        215,884Nonaccrual
      interest
                        
                        
                        79,495
                        
                        
                        
                        
                        47,881
                        
                        
                        
                        
                        87,081Restricted
      stock
                        
                        
                        49,343
                        
                        
                        
                        
                        50,499
                        
                        
                        
                        
                        63,956Nonqualified
      stock options
                        
                        
                        31,434
                        
                        
                        
                        
                        11,327
                        
                        
                        
                        
                        -Other
                        
                        
                        35,526
                        
                        
                        
                        
                        15,770
                        
                        
                        
                        
                        15,769Total
      deferred tax assets
                        
                        
                        4,798,419
                        
                        
                        
                        
                        3,906,906
                        
                        
                        
                        
                        3,590,955Deferred
      tax liabilities:Federal
      Home Loan Bank dividends
                        
                        
                        116,291
                        
                        
                        
                        
                        111,947
                        
                        
                        
                        
                        83,510Depreciation
                        
                        
                        70,018
                        
                        
                        
                        
                        85,556
                        
                        
                        
                        
                        120,217Prepaid
      Expense
                        
                        
                        76,181
                        
                        
                        
                        
                        -
                        
                        
                        
                        
                        -Unrealized
      securities holding gains
                        
                        
                        11,518
                        
                        
                        
                        
                        -
                        
                        
                        
                        
                        -Other
                        
                        
                        -
                        
                        
                        
                        
                        655
                        
                        
                        
                        
                        -Total
      deferred tax liabilities
                        
                        
                        274,008
                        
                        
                        
                        
                        198,158
                        
                        
                        
                        
                        203,727Net
      deferred tax assets
                        
                        $
                        4,524,411
                        
                        
                        
                        $
                        3,708,748
                        
                        
                        
                        $
                        3,387,228
 The
amounts presented for the tax effects of temporary differences are based upon
estimates and assumptions and could vary from amounts ultimately reflected on
the Company's tax returns.
 
 Income
tax payable was $159,851 at December 31, 2008. Income tax payable was $99,212 at
December 31, 2007.
 
 The
Company or one of its subsidiaries files income tax returns in the U.S. Federal
jurisdiction and the state of California jurisdiction.  The Company is
no longer subject to U.S. federal income tax examinations and California
Franchise tax examinations by tax authorities for years before 2005 and 2004,
respectively.
 
 The
Company adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income
Taxes,on January 1, 2007.  No adjustments were identified for
unrecognized tax benefits which would require an adjustment to the January 1,
2007 beginning balance of retained earnings.  There were also no
adjustments identified for unrecognized tax benefits which would require an
adjustment to the income statement for the years ended December 31, 2008 or
2007.   During the years ended December 31, 2008 and 2007, the
Company recognized no interest and penalties.
  77
 NOTE
K—EARNINGS PER SHARE
 
 The
following is the computation of basic and diluted earnings per share for the
years ended December 31:
 
 2008
                          
                          
                          
                          2007
                          
                          
                          
                          2006Basic:Net
      income
                          
                          $
                          3,315,361
                          
                          
                          
                          $
                          4,343,538
                          
                          
                          
                          $
                          3,991,759Weighted-average
      common shares outstanding
                          
                          
                          2,263,045
                          
                          
                          
                          
                          2,241,104
                          
                          
                          
                          
                          2,247,231Earnings
      per share
                          
                          $
                          1.46
                          
                          
                          
                          $
                          1.94
                          
                          
                          
                          $
                          1.78Diluted:Net
      income
                          
                          $
                          3,315,361
                          
                          
                          
                          $
                          4,343,538
                          
                          
                          
                          $
                          3,991,759Weighted-average
      common shares outstanding
                          
                          
                          2,263,045
                          
                          
                          
                          
                          2,241,104
                          
                          
                          
                          
                          2,247,231Net
      effect of dilutive share-based awards –
                            based
      on the treasury stock method using
                            average
      market price
                          
                          
                          29,686
                          
                          
                          
                          
                          72,484
                          
                          
                          
                          
                          121,987Weighted-average
      common shares outstanding
                            and common stock
      equivalents
                          
                          
                          2,292,731
                          
                          
                          
                          
                          2,313,588
                          
                          
                          
                          
                          2,369,218Earnings
      per share - assuming dilution
                          
                          $
                          1.45
                          
                          
                          
                          $
                          1.88
                          
                          
                          
                          $
                          1.68
 
 Nonvested
restricted shares are included in the computation of diluted earnings per share
using the treasury stock method.  Vested restricted shares are
outstanding for both basic and diluted earnings per share. In addition,
options to purchase 37,410 common shares at $23.50 to $28.54 and 16,600 shares
of restricted stock were outstanding during 2008 but were excluded from the
computation of diluted earnings per share because the exercise price or issuance
price was greater than the average market price of the common
shares.
 
 NOTE
L—EQUITY INCENTIVE PLANS
  The
Company has a stock option plan (the 1996 Plan), effective March 31, 1996 and
terminated on May 14, 2002 under which incentive and nonstatutory stock options,
as defined under the Internal Revenue Code, were granted.  The 1996
Plan was administered by a Committee appointed by the Board.  No
additional options are available for granting under this plan; however, there
are unexercised options currently outstanding under this plan.  The
options granted under this plan have an exercise period of 10 years, a portion
of which were subject to a graded vesting schedule of 20% per year.
 
  78
 NOTE
L—EQUITY INCENTIVE PLANS (Continued)
  The
options generally vest based on 5 years of continuous service and have 10-year
contractual terms.  No options were granted in 2005 and
2006.  There were 10,000 options granted in June 2007 and 7,410
options granted in December 2007.  There were 10,000 options granted
in January 2008.  The Company has 2,195 options available to grant
under this plan at December 31, 2008.
 
 The
Company approved an equity incentive plan (the 2007 Plan), effective February
21, 2007 and terminating February 20, 2017, under which stock options,
restricted stock, stock appreciation rights and stock bonuses may be granted.
The 2007 Plan is administered by a Committee appointed by the Board. Options
representing 231,963 shares of the Company’s authorized and unissued common
stock may be granted under the Plan by the Committee to directors and employees
of the Company at a price to be determined by the Committee but shall not be
less than 100% of the fair market value of the shares on the date the incentive
stock option is granted. The options generally vest based on 5 years of
continuous service and have 10-year contractual terms. There were 10,000 options
granted in April 2008. The Company has 221,963 options available to grant under
this plan at December 31, 2008.
 
 The fair
value of options granted is estimated on the date of grant using the
Black-Scholes option pricing model with the following assumptions
used:
 January
      2008
                                    
                                    April
      2008Expected
      Life in Years
                                    
                                    
                                    7.00
                                    
                                    
                                    
                                    7.00Risk
      Free Interest Rate
                                    
                                    
                                    3.32
                                    %
                                    
                                    
                                    3.21
                                    %Expected
      Stock Price Volatility
                                    
                                    
                                    35.00
                                    %
                                    
                                    
                                    35.70
                                    %Expected
      Cash Dividend Yield
                                    
                                    
                                    2.80
                                    %
                                    
                                    
                                    2.33
                                    %Expected
      Annual Forfeiture Rate
                                    
                                    
                                    0.00
                                    %
                                    
                                    
                                    0.00
                                    %
 
 The
Company uses historical data to estimate expected cash dividend yield, expected
life in years, expected stock price volatility and expected annual forfeiture
rate within the valuation model. Expected volatilities are based on the
historical volatility of the Company’s stock.  The expected life of
options represents the period of time that options granted are expected to be
outstanding.  The risk-free rate for periods within the contractual
life of the option is based on the U.S. Treasury yield curve in effect at the
time of grant.
 
 The
Company granted a stock bonus under the 2002 plan in July of 2006, consisting of
29,000 shares of restricted stock, with a fair value at grant date of
$26.25.  The employees have dividend and voting rights at the time of
grant, regardless of whether they are vested in these shares.  This
restricted stock vests over three to five years.
 79
 NOTE
L—EQUITY INCENTIVE PLANS (Continued)
 
 A summary
of stock option activity follows for the years ended December 31:
 
 
 Incentive
      Stock Options2008
                    
                    
                    
                    2007
                    
                    
                    
                    2006Weighted-Average
                    
                    
                    
                    
                    
                    Weighted-Average
                    
                    
                    
                    
                    
                    Weighted-AverageExercise
                    
                    
                    
                    
                    
                    Exercise
                    
                    
                    
                    
                    
                    ExercisePrice
                    
                    
                    Shares
                    
                    
                    Price
                    
                    
                    Shares
                    
                    
                    Price
                    
                    
                    SharesShares
      under option at beginning of year
                    
                    $
                    17.40
                    
                    
                    
                    78,773
                    
                    $
                    17.00
                    
                    
                    92,621
                    
                    $
                    14.64
                    
                    
                    133,085Options
      granted
                    
                    
                    23.50
                    
                    
                    
                    10,000Options
      exercised
                    
                    
                    14.75
                    
                    
                    
                    (25,874
                    )
                    
                    14.69
                    
                    
                    (13,848
                    )
                    
                    8.90
                    
                    
                    (39,264
                    )Options
      forfeited or expired
                    
                    
                    0.00
                    
                    
                    
                    0
                    
                    
                    0.00
                    
                    
                    
                    0
                    
                    
                    
                    20.71
                    
                    
                    (1,200
                    )Shares
      under option at end of year
                    
                    
                    19.46
                    
                    
                    
                    62,899
                    
                    
                    17.40
                    
                    
                    
                    78,773
                    
                    
                    
                    17.00
                    
                    
                    92,621Options
      exercisable at end of year
                    
                    
                    18.70
                    
                    
                    
                    52,899
                    
                    
                    16.78
                    
                    
                    
                    66,323
                    
                    
                    
                    15.63
                    
                    
                    67,721Weighted-average
      fair value of options granted during the year
                    
                    
                    7.12
   Nonstatutory Stock
      Options2008
                                            
                                            
                                            
                                            2007
                                            
                                            
                                            
                                            2006Weighted-Average
                                            
                                            
                                            
                                            
                                            
                                            Weighted-Average
                                            
                                            
                                            
                                            
                                            
                                            Weighted-AverageExercise
                                            
                                            
                                            
                                            
                                            
                                            Exercise
                                            
                                            
                                            
                                            
                                            
                                            ExercisePrice
                                            
                                            
                                            Shares
                                            
                                            
                                            Price
                                            
                                            
                                            Shares
                                            
                                            
                                            Price
                                            
                                            
                                            SharesShares
      under option at beginning of year
                                            
                                            $
                                            11.85
                                            
                                            
                                            
                                            91,532
                                            
                                            $
                                            8.12
                                            
                                            
                                            120,438
                                            
                                            $
                                            8.07
                                            
                                            
                                            185,300Options
      granted
                                            
                                            
                                            25.70
                                            
                                            
                                            
                                            10,000
                                            
                                            
                                            27.48
                                            
                                            
                                            17,410Options
      exercised
                                            
                                            
                                            8.67
                                            
                                            
                                            
                                            (23,162
                                            )
                                            
                                            8.06
                                            
                                            
                                            
                                            (46,316
                                            )
                                            
                                            
                                            7.95
                                            
                                            
                                            (64,862
                                            )Shares
      under option at end of year
                                            
                                            
                                            14.56
                                            
                                            
                                            
                                            78,370
                                            
                                            
                                            11.85
                                            
                                            
                                            
                                            91,532
                                            
                                            
                                            
                                            8.12
                                            
                                            
                                            120,438Options
      exercisable at end of year
                                            
                                            
                                            10.21
                                            
                                            
                                            
                                            57,900
                                            
                                            
                                            8.75
                                            
                                            
                                            
                                            76,592
                                            
                                            
                                            
                                            8.12
                                            
                                            
                                            120,438Weighted-average
      fair value of options granted during the year
                                            
                                            
                                            8.36
                                            
                                            
                                            
                                            
                                            
                                            
                                            8.68
 
 
 
 
 80
 NOTE
L—EQUITY INCENTIVE PLANS (Continued)
 
 Following
is the intrinsic value and weighted average contractual term of stock options
outstanding for the years ended December 31:
 
 Incentive
      Stock Options2008
                      
                      
                      2007
                      
                      
                      2006Intrinsic
      value:Outstanding
      shares
                      
                      $
                      (400,014
                      )
                      
                      $
                      610,396
                      
                      
                      $
                      1,019,333Exercisable
      shares
                      
                      
                      (296,014
                      )
                      
                      
                      555,081
                      
                      
                      
                      837,751Weighted
      averageremaining
      contractual term:Outstanding
      shares
                      
                      5.56
      years
                      
                      
                      5.21
      years
                      
                      
                      6.15
      yearsExercisable
      shares
                      
                      4.73
      years
                      
                      
                      5.01
      years
                      
                      
                      5.71
      years
 
 Nonstatutory
      Stock Options2008
                      
                      
                      2007
                      
                      
                      2006Intrinsic
      value:Outstanding
      shares
                      
                      $
                      (114,155
                      )
                      
                      $
                      1,217,399
                      
                      
                      $
                      2,392,987Exercisable
      shares
                      
                      
                      167,352
                      
                      
                      
                      1,255,745
                      
                      
                      
                      2,392,987Weighted
      averageremaining
      contractual term:Outstanding
      shares
                      
                      4.98
      years
                      
                      
                      4.02
      years
                      
                      
                      2.02
      yearsExercisable
      shares
                      
                      1.88
      years
                      
                      
                      1.49
      years
                      
                      
                      2.02
      years
 Upon the
exercise of stock options, new shares are issued.  The total amount of
cash received from the exercise of stock options during 2008, 2007 and 2006 was
$582,557, $576,483 and $864,993, respectively.  The tax benefits
realized for the tax deductions from stock options exercised during 2008, 2007
and 2006 was $158,718, $407,889 and $459,493, respectively.
 
 A summary
of the status of the Company’s nonvested shares and changes during the years
ended December 31are presented below:
 
 Incentive
      Stock Options2008
                      
                      
                      2007
                      
                      
                      2006Weighted-Average
                      
                      
                      
                      
                      
                      Weighted-Average
                      
                      
                      
                      
                      
                      Weighted-AverageGrant-Date
                      
                      
                      
                      
                      
                      Grant-Date
                      
                      
                      
                      
                      
                      Grant-DateNonvested
      Shares
                      
                      Shares
                      
                      
                      Fair
      Value
                      
                      
                      Shares
                      
                      
                      Fair
      Value
                      
                      
                      Shares
                      
                      
                      Fair
      ValueNonvested
      at beginning of year
                      
                      
                      12,450
                      
                      
                      $
                      7.68
                      
                      
                      
                      24,900
                      
                      
                      $
                      7.68
                      
                      
                      
                      39,150
                      
                      
                      $
                      7.68Granted
                      
                      
                      10,000
                      
                      
                      
                      7.12Vested
                      
                      
                      (12,450
                      )
                      
                      
                      7.68
                      
                      
                      
                      (12,450
                      )
                      
                      
                      7.68
                      
                      
                      
                      (13,050
                      )
                      
                      
                      7.68Forfeited
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      (1,200
                      )
                      
                      
                      7.68Nonvested
      at end of year
                      
                      
                      10,000
                      
                      
                      
                      7.12
                      
                      
                      
                      12,450
                      
                      
                      
                      7.68
                      
                      
                      
                      24,900
                      
                      
                      
                      7.68
  81
 NOTE
L—EQUITY INCENTIVE PLANS (Continued)
 
 Nonstatutory
      Stock Options2008
                      
                      
                      2007Weighted-Average
                      
                      
                      
                      
                      
                      Weighted-
                        AverageGrant-Date
                      
                      
                      
                      
                      
                      Grant-DateNonvested
      Shares
                      
                      Shares
                      
                      
                      Fair
      Value
                      
                      
                      Shares
                      
                      
                      Fair
      ValueNonvested
      at beginning of year
                      
                      
                      14,940
                      
                      
                      $
                      9.00
                      
                      
                      
                      0Granted
                      
                      
                      10,000
                      
                      
                      
                      8.36
                      
                      
                      
                      17,410
                      
                      
                      $
                      8.68Vested
                      
                      
                      (4,470
                      )
                      
                      
                      8.26
                      
                      
                      
                      (2,470
                      )
                      
                      
                      6.79Nonvested
      at end of year
                      
                      
                      20,470
                      
                      
                      
                      8.85
                      
                      
                      
                      14,940
                      
                      
                      
                      9.00
  As of
December 30, 2008 and 2007 there was $215,891 and $125,918, respectively, of
total unrecognized compensation cost related to nonvested stock options granted
under the Plan.  That cost is expected to be recognized over a
weighted-average period of 3.7 years.  The total fair value of shares
vested during the years ended December 31, 2008, 2007 and 2006, was $132,553,
$112,379 and $100,224, respectively.
 
 A summary
of restricted stock activity follows for the years ended December 31, 2008 and
2007:
 2008
                        
                        2007Weighted-Average
                        
                        Aggregate
                        
                        
                        
                        
                        Weighted-Average
                        
                        AggregateGrant-Date
                        
                        Intrinsic
                        
                        
                        
                        
                        Grant-Date
                        
                        IntrinsicRestricted
      Stock
                        
                        Shares
                        
                        
                        Fair
      Value
                        
                        Value
                        
                        Shares
                        
                        
                        Fair
      Value
                        
                        ValueNonvested
      at beginning of year
                        
                        
                        22,800
                        
                        
                        $
                        26.25Granted
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        29,000
                        
                        
                        $
                        26.25Shares
      Vested and Issued
                        
                        
                        (6,200
                        )
                        
                        $
                        26.25
                        
                        
                        
                        
                        (6,200
                        )
                        
                        $
                        26.25Nonvested
      at end of year
                        
                        
                        16,600
                        
                        
                        $
                        26.25
                        
                        $217,460
                        
                        
                        22,800
                        
                        
                        $
                        26.25
                        
                        $573,420
 As of
December 31, 2008 and 2007, there was $354,375 and $517,125 of total
unrecognized compensation cost related to nonvested restricted
stock.  That cost is expected to be recognized over a weighted-average
period of 2.5 years and 3.5 years, respectively.
 
 Total
compensation cost for all share-based payments recognized in net income for
2008, 2007 and 2006 totaled $133,916, $223,172 and $106,871, respectively, which
is net of the related tax benefits for 2008, 2007 and 2006 of $93,639, $156,050
and $74,728, respectively.
 82
 NOTE
M—RELATED PARTY TRANSACTIONS
 The
Company has entered into transactions with its directors, executive officers and
their affiliates (related parties).  Such transactions were made in
the ordinary course of business on substantially the same terms and conditions,
including interest rates and collateral, as those prevailing at the same time
for comparable transactions with other customers, and did not, in the opinion of
management, involve more than normal credit risk or present other unfavorable
features.  The following is a summary of the aggregate activity
involving related party borrowers at December 31, 2008 and 2007:
  2008
                    
                    
                    2007Loans
      outstanding at beginning of year
                    
                    $
                    2,461,000
                    
                    
                    $
                    2,657,000Loans
      disbursements
                    
                    
                    821,000
                    
                    
                    
                    703,000Loan
      repayments
                    
                    
                    (1,839,000
                    )
                    
                    
                    (899,000
                    )Loans
      outstanding at end of year
                    
                    $
                    1,443,000
                    
                    
                    $
                    2,461,000
 
 At
December 31, 2008, commitments to related parties of approximately $1,412,000
were undisbursed.  Deposits received from directors and officers
totaled $4,094,000 and $4,621,000 at December 31, 2008 and 2007,
respectively.
 
 The
Company leases its Glen Ellen office from a director of the Company under a
noncancellable operating lease.  Lease expense for the years ended
December 31, 2008 and 2007 was $15,560 and $15,294, respectively. The remaining
lease commitment is approximately $72,794 expiring March 2013.  When
the current term expires the Company has the option to extend the lease for one
additional 5 year term.  The lease expense increases annually based
upon the Consumer Price Index, but not less than 4% annually.
 
 NOTE
N—COMMITMENTS AND CONTINGENT LIABILITIES
 
 Lease
Commitments:  The Company
leases its three Sonoma offices, the Glen Ellen office and the Banco de Sonoma
office under noncancelable operating leases with remaining terms of
approximately 6 months, two years, one year, four years and five years,
respectively.  All of the leases require adjustments to the base rent
for changing price indices and two have a minimum annual increase of four
percent.  The Sonoma main office lease and the Sonoma Finance Center
lease have the option to renew for two consecutive five-year terms and the
Sonoma annex office has an option to renew for one five-year period and one
four-year period. The Glen Ellen office and the Banco de Sonoma office lease
each have an option to renew for one additional five-year term.  The
following table summarizes future minimum commitments under the noncancelable
operating leases.
  Year
      ended December 31,2009
                      
                      $
                      249,4222010
                      
                      
                      67,1922011
                      
                      
                      41,2952012
                      
                      
                      42,7082013
                      
                      
                      29,943Thereafter
                      
                      
                      2,120$
                      432,680
 
 
 
 
 
 
 
 83
 NOTE
N—COMMITMENTS AND CONTINGENT LIABILITIES (Continued)
  Rental
expense was $393,000 in 2008, $381,000 in 2007 and $364,000 in
2006.
 
 Financial Instruments with
Off-Balance-Sheet Risk:  The Company's financial statements do
not reflect various commitments and contingent liabilities which arise in the
normal course of business and which involve elements of credit risk, interest
rate risk and liquidity risk.  These commitments and contingent
liabilities are commitments to extend credit and standby letters of
credit.  A summary of the Company's commitments and contingent
liabilities at December 31 is as follows:
 Contractual
      Amounts2008
                                      
                                      
                                      2007Commitments
      to extend credit
                                      
                                      $
                                      42,284,000
                                      
                                      
                                      $
                                      51,458,000Standby
      letters of credit
                                      
                                      
                                      118,000
                                      
                                      
                                      
                                      158,000
 Commitments
to extend credit and standby letters of credit include exposure to some credit
loss in the event of nonperformance of the customer.  The Company's
credit policies and procedures for credit commitments and financial guarantees
are the same as those for extensions of credit that are recorded on the balance
sheet.  Because these instruments have fixed maturity dates, and
because many of them expire without being drawn upon, they do not generally
present any significant liquidity risk to the Company.
 
 Commitments
to extend credit are agreements to lend to a customer as long as there is no
violation of any condition established in the contract.  Commitments
generally have fixed expiration dates or other termination clauses and may
require payment of a fee. The Company evaluates each customer’s credit
worthiness on a case-by-case basis.  The amount of collateral
obtained, if deemed necessary by the Company upon extension of credit, is based
on management’s credit evaluation of the customer.  Collateral held
varies but may include accounts receivable, inventory, property, plant, and
equipment, certificates of deposits and income-producing commercial
properties.
 
 Standby
letters of credit are conditional commitments issued by the Company to guarantee
the performance of  a customer to a third party.  Those
guarantees are primarily issued to support public and private borrowing
arrangements.  The credit risk involved in issuing letters of credit
is essentially the same as that involved in extending facilities to
customers.
 
 The
Company has not incurred any losses on its commitments in 2008, 2007 or
2006.
 
 As a
guarantor of its customers’ credit card accounts, the Company is contingently
liable for credit card receivable balances held by another financial institution
should the customers default.  The total amount guaranteed as of
December 31, 2008 and 2007 was $580,000 and $655,000, respectively.
 NOTE
O—CONCENTRATIONS OF CREDIT RISK
  Most of
the Company's business activity is with customers located within the State of
California, primarily in Sonoma County.  The economy of the Company's
primary service area is heavily dependent on the area's major industries which
are tourism and agriculture, especially wineries, dairies and cheese
producers.  General economic conditions or natural disasters affecting
the primary service area or its major industries could affect the ability of
customers to repay loans and the value of real property used as
collateral.
 84
 NOTE
O—CONCENTRATIONS OF CREDIT RISK (Continued)
 
 The
composition of the loan portfolio by credit type is set forth in Note
D.  Note D does not include unfunded loan commitments, which represent
14.0% of loans outstanding.  While the Company has
approximately  91.3% of its loan portfolio centered in real estate
secured loans within its service area, the loans in this category are
diversified.  Based on outstanding loan commitments (“total loans”),
the Company has the following loan concentrations:  Non-owner occupied
construction (6.92%), owner-occupied construction (3.39%), land loans (7.78%),
mixed-use commercial real estate (10.14%), industrial and warehouse commercial
real estate (7.69%), retail commercial real estate (8.98%), office commercial
real estate (6.39%), multi-family commercial real estate (7.34%) and loans to
the tourism industries (3.38%).  Standby letters of credit were
granted primarily to commercial borrowers.  The Company, as a matter
of policy, does not extend credit to any single borrower or group of related
borrowers on a secured basis in excess of 25% of its unimpaired capital
(shareholders' equity plus the allowance for credit losses) and on an unsecured
basis in excess of 15% of its unimpaired capital.
 
 The
concentrations of investments are set forth in Note C.  The Company
places its investments primarily in financial instruments backed by the U.S.
Government and its agencies or by high quality financial institutions,
municipalities or corporations.  The Company has significant funds
deposited with four correspondent banks.  In addition, deposits with
two correspondent banks were in excess of the federally insured limit by
$309,169 at December 31, 2008.  While management recognizes the
inherent risks involved in such concentrations, this concentration provides the
Company with an effective and cost efficient means of managing its liquidity
position and item processing needs.  Management closely monitors the
financial condition of their correspondent banks on a continuous
basis.  The Company also maintains additional deposit accounts with
other correspondent banks should management determine that a change in its
correspondent banking relationship would be appropriate.
 
 At
December 31, 2008, the Company had life insurance policies with cash surrender
values of $2,716,604, $2,027,179, $2,019,301 and $1,996,317 with four insurance
companies, which represented 8.8%, 6.6%, 6.5% and 6.5%, respectively, of the
Company's net worth.  Management closely monitors the financial
condition and rating of these insurance companies on a regular
basis.
 
 NOTE
P—REGULATORY MATTERS
  Banking
regulations limit the amount of cash dividends that may be paid without prior
approval of the Bank's regulatory agency.  Cash dividends are limited
to the lesser of retained earnings, if any, or net income for the last three
years, net of the amount of any other distributions made to shareholders during
such periods.  As of December 31, 2008, $7,440,441 was available for
cash dividend distribution without prior approval.
 
 The Bank
is subject to various regulatory capital requirements administered by its
primary federal regulator, the Federal Deposit Insurance Corporation
(FDIC).  Failure to meet minimum capital requirements can initiate
certain mandatory—and possibly additional discretionary—actions by regulators
that, if undertaken, could have a direct material effect on the Bank’s financial
statements.  Under capital adequacy guidelines and the regulatory
framework for prompt corrective action, the Bank must meet specific capital
guidelines that involve quantitative measures of the Bank’s assets, liabilities,
and certain off-balance-sheet items as calculated under regulatory
accounting practices.  The Bank’s capital amounts and classification
are also subject to qualitative judgments by the regulators about components,
risk weightings, and other factors.
 
 85
 NOTE
P—REGULATORY MATTERS (Continued)
  Quantitative
measures established by regulation to ensure capital adequacy require the Bank
to maintain minimum amounts and ratios (set forth in the table below) of total
and Tier I capital (as defined in the regulations) to risk-weighted assets (as
defined), and of Tier I capital (as defined) to average assets (as
defined).  Management believes, as of December 31, 2008, that the Bank
meets all capital adequacy requirements to which it is subject.
 
 As of
December 31, 2008, the most recent notification from the FDIC categorized the
Bank as well capitalized under the regulatory framework for prompt corrective
action.  To be categorized as well capitalized the Bank must maintain
minimum total risk-based, Tier I risk-based and Tier I leverage ratios as set
forth in the table. There are no conditions or events since that notification
that management believes have changed the institution’s category.  The
Bank’s actual capital amounts and ratios are also presented in the
table.
 Actual
                                                  For
      CapitalAdequacy
                                                  To
      Be Well Capitalized Under
                                                    Prompt
      Corrective
                                                    Action
      ProvisionsAmount
                                                  Ratio
                                                  Purposes Amount
                                                  Ratio
                                                  Amount
                                                  RatioAs
      of December 31, 2008:
                                                    Total
      Capital
                                                    (to
      Risk Weighted Assets)
                                                  $
      32,640
                                                  11.3%
                                                  ≥$
      23,077
                                                  ≥8.0%
                                                  ≥$
      28,846
                                                  ≥10.0%Tier
      I Capital
                                                    (to
      Risk Weighted Assets)
                                                  $
      29,017
                                                  10.1%
                                                  ≥$
      11,538
                                                  ≥4.0%
                                                  ≥$
      17,308
                                                  ≥ 6.0%Tier
      I Capital
                                                    (to
      Average Assets)
                                                  $
      29,017
                                                  9.2%
                                                  ≥$
      12,586
                                                  ≥4.0%
                                                  ≥$
      15,732
                                                  ≥  5.0%As
      of December 31, 2007:Total
      Capital
                                                    (to
      Risk Weighted Assets)
                                                  $
      29,996
                                                  10.8%
                                                  ≥$
      22,310
                                                  ≥8.0%
                                                  ≥$
      27,887
                                                  ≥10.0%Tier
      I Capital
                                                    (to
      Risk Weighted Assets)
                                                  $
      26,507
                                                  9.5%
                                                  ≥$
      11,155
                                                  ≥4.0%
                                                  ≥$
      16,732
                                                  ≥  6.0%Tier
      I Capital
                                                    (to
      Average Assets)
                                                  $
      26,507
                                                  9.0%
                                                  ≥$
      11,761
                                                  ≥4.0%
                                                  ≥$
      14,701
                                                  ≥  5.0%
 
 
 
 86
 NOTE
Q—CONDENSED FINANCIAL INFORMATION OF THE PARENT COMPANY
 
 A
condensed balance sheet as of December 31, 2008 and 2007 and the related
condensed statement of operations and cash flows for the years ended December
31, 2008 and 2007 for Sonoma Valley Bancorp (parent company only) are presented
as follows:
 
 Condensed
Balance Sheets
 December
31, 2008 and 2007
 2008
                  
                  
                  2007AssetsCash
                  
                  $
                  171,504
                  
                  
                  $
                  55,380Other assets
                  
                  
                  841,500
                  
                  
                  
                  947,911Investment in common stock of
      subsidiary
                  
                  
                  30,226,920
                  
                  
                  
                  27,218,520Total
      assets
                  
                  $
                  31,239,924
                  
                  
                  $
                  28,221,811
 
 LiabilitiesAccrued expenses
                  
                  $
                  379,828
                  
                  
                  $
                  287,531Shareholders’
      equityCommon stock
                  
                  
                  16,402,084
                  
                  
                  
                  15,578,903Additional
      paid-in-capital
                    Retained
      earnings and other equity
                  
                  
                  2,577,855
      11,880,157
                  
                  
                  
                  2,455,409
      9,899,968Total
      liabilities and shareholders’ equity
                  
                  $
                  31,239,924
                  
                  
                  $
                  28,221,811
 
 
 Condensed
Statements of Operations
 For the
years ended December 31, 2008, 2007 and 2006
 
 2008
                  
                  
                  2007
                  
                  
                  2006Dividend
      from subsidiary
                  
                  $
                  1,000,000
                  
                  
                  $
                  3,000,000
                  
                  
                  $
                  1,750,000Expenses
                  
                  
                  1,179,574
                  
                  
                  
                  892,962
                  
                  
                  
                  583,724Income
      (loss) before income taxes and equity
                    in undistributed income of
      subsidiary
                  
                  
                  (179,574
                  )
                  
                  
                  2,107,038
                  
                  
                  
                  1,166,276Equity
      in undistributed net income of subsidiary
                  
                  
                  2,956,932
                  
                  
                  
                  1,862,267
                  
                  
                  
                  2,621,241Income
      tax benefit
                  
                  
                  538,003
                  
                  
                  
                  374,233
                  
                  
                  
                  204,242Net
      income
                  
                  $
                  3,315,361
                  
                  
                  $
                  4,343,538
                  
                  
                  $
                  3,991,759
 
 
 
 
 87
 NOTE
Q—CONDENSED FINANCIAL INFORMATION OF THE PARENT COMPANY (Continued)
  Condensed
Statements of Cash Flows
 For the
years ended December 31, 2008, 2007 and 2006
 
 2008
                  
                  
                  2007
                  
                  
                  2006Operating
      activities:Net income
                  
                  $
                  3,315,361
                  
                  
                  $
                  4,343,538
                  
                  
                  $
                  3,991,759Adjustments to reconcile net
      income to net cashprovided by
      operating activities:Equity in undistributed net
      income of subsidiary
                  
                  
                  (2,956,932
                  )
                  
                  
                  (1,862,267
                  )
                  
                  
                  (2,621,241
                  )Stock
      options and restricted stock granted
                  
                  
                  227,555
                  
                  
                  
                  379,223
                  
                  
                  
                  181,599Net change in other
      assets
                  
                  
                  250,452
                  
                  
                  
                  232,383
                  
                  
                  
                  (15,100
                  )Net change in accrued
      expenses
                  
                  
                  92,297
                  
                  
                  
                  7,931
                  
                  
                  
                  58,457Net
      cash provided by operating activities
                  
                  
                  928,733
                  
                  
                  
                  3,100,808
                  
                  
                  
                  1,595,474
 
 Financing
      activities:Stock
    repurchases
                              
                              
                              (21,940
                              )
                              
                              
                              (2,933,237
                              )
                              
                              
                              (1,436,151
                              )Stock options
      exercised
                              
                              
                              582,557
                              
                              
                              
                              576,482
                              
                              
                              
                              864,993Cash dividends
    paid
                              
                              
                              (1,373,226
                              )
                              
                              
                              (1,371,471
                              )
                              
                              
                              (1,252,957
                              )Net
      cash used by financing activities
                              
                              
                              (812,609
                              )
                              
                              
                              (3,728,226
                              )
                              
                              
                              (1,824,115
                              )Net
      change in cash and cash equivalents
                              
                              
                              116,124
                              
                              
                              
                              (627,418
                              )
                              
                              
                              (228,641
                              )Cash
      and cash equivalents at beginning of year
                              
                              
                              55,380
                              
                              
                              
                              682,798
                              
                              
                              
                              911,439Cash
      and cash equivalents at end of year
                              
                              $
                              171,504
                              
                              
                              $
                              55,380
                              
                              
                              $
                              682,798
 
 
 88
 NOTE
R—FAIR VALUES OF FINANCIAL INSTRUMENTS
  Statement
of Financial Accounting Standards No. 107, Disclosures about Fair Value of
Financial Instruments, requires disclosure of fair value information
about financial instruments, whether or not recognized in the balance
sheet.  In cases where quoted market prices are not available, fair
values are based on estimates using present value or other valuation
techniques.  Those techniques are significantly affected by the
assumptions used, including the discount rate and estimates of future cash
flows.  In that regard, the derived fair value estimates cannot be
substantiated by comparison to independent markets and, in many cases could not
be realized in immediate settlement of the instruments.  Statement No.
107 excludes certain financial instruments and all nonfinancial instruments from
its disclosure requirements.  Accordingly, the aggregate fair value
amounts presented do not represent the underlying value of the Company as a
whole.
  The
estimated fair values of the Company and Subsidiary's financial instruments are
as follows at December 31:
 
 2008
                                                                
                                                                
                                                                2007Carrying
      Amount
                                                                
                                                                
                                                                Estimated
      Fair Value
                                                                
                                                                
                                                                Carrying
      Amount
                                                                
                                                                
                                                                Estimated
      Fair ValueFinancial
      assets:Cash and due from
      banks
                                                                
                                                                $
                                                                17,959,020
                                                                
                                                                
                                                                $
                                                                17,959,020
                                                                
                                                                
                                                                $
                                                                6,268,091
                                                                
                                                                
                                                                $
                                                                6,268,091Federal funds
soldInterest-bearing due from
      banks
                                                                
                                                                
                                                                274,035
                                                                
                                                                
                                                                
                                                                274,035
                                                                
                                                                
                                                                
                                                                3,065,543
                                                                
                                                                
                                                                
                                                                3,065,543Investment
      securities available-for-sale
                                                                
                                                                
                                                                6,578,924
                                                                
                                                                
                                                                
                                                                6,578,924
                                                                
                                                                
                                                                
                                                                8,203,190
                                                                
                                                                
                                                                
                                                                8,203,190Investment
      securities held-to-maturity
                                                                
                                                                
                                                                13,862,911
                                                                
                                                                
                                                                
                                                                14,028,111
                                                                
                                                                
                                                                
                                                                14,554,224
                                                                
                                                                
                                                                
                                                                14,754,249Loans
      and lease financingreceivable, net
                                                                
                                                                
                                                                262,376,784
                                                                
                                                                
                                                                
                                                                268,700,000
                                                                
                                                                
                                                                
                                                                246,738,218
                                                                
                                                                
                                                                
                                                                245,521,222Accrued
      interest receivable
                                                                
                                                                
                                                                1,678,547
                                                                
                                                                
                                                                
                                                                1,678,547
                                                                
                                                                
                                                                
                                                                1,682,209
                                                                
                                                                
                                                                
                                                                1,682,209Cash
      surrender value of life insurance
                                                                
                                                                
                                                                10,777,482
                                                                
                                                                
                                                                
                                                                10,777,482
                                                                
                                                                
                                                                
                                                                10,354,153
                                                                
                                                                
                                                                
                                                                10,354,153Financial
      liabilities:Deposits
                                                                
                                                                
                                                                253,945,501
                                                                
                                                                
                                                                
                                                                255,702,857
                                                                
                                                                
                                                                
                                                                236,047,699
                                                                
                                                                
                                                                
                                                                236,347,423Accrued
      interest payable
                                                                
                                                                
                                                                112,405
                                                                
                                                                
                                                                
                                                                112,405
                                                                
                                                                
                                                                
                                                                150,109
                                                                
                                                                
                                                                
                                                                150,109Federal Home Loan BankBorrowings
                                                                
                                                                
                                                                30,000,000
                                                                
                                                                
                                                                
                                                                30,600,000
                                                                
                                                                
                                                                
                                                                27,500,000
                                                                
                                                                
                                                                
                                                                27,638,811
  The
carrying amounts in the preceding table are included in the balance sheet under
the applicable captions.
 
 The
following methods and assumptions were used by the Company in estimating its
fair value disclosures for financial instruments:
 
 Cash, due
from banks and federal funds sold:  The carrying amount is a
reasonable estimate of fair value.
  89
   Investment
securities:  Fair values for investment securities are based on quoted
market prices, where available.  If quoted market prices are not
available, fair values are based on quoted market prices of comparable
instruments.  The carrying amount of accrued interest receivable
approximates its fair value.
 
 Loans and
lease financing receivables, net:  For variable-rate loans and leases
that reprice frequently and fixed rate loans and leases that mature in the near
future, with no significant change in credit risk, fair values are based on
carrying amounts.  The fair values for other fixed rate loans and
leases are estimated using discounted cash flow analysis, based on interest
rates currently being offered for loans or leases with similar terms to
borrowers of similar credit quality.  Loan and lease fair value
estimates include judgments regarding future expected loss experience and risk
characteristics and are adjusted for the allowance for loan and lease
losses.  The carrying amount of accrued interest receivable
approximates its fair value.
  Cash
surrender value of life insurance:  The carrying amount approximates
its fair value.
 
 Deposits:  The
fair values disclosed for demand deposits (for example, interest-bearing
checking accounts and passbook accounts) are, by definition, equal to the amount
payable on demand at the reporting date (that is, their carrying
amounts).  The fair values for certificates of deposit are estimated
using a discounted cash flow calculation that applies interest rates currently
being offered on certificates to a schedule of aggregated contractual maturities
on such time deposits.  The carrying amount of accrued interest
payable approximates fair value.
 
 Federal
Home Loan Bank borrowings:  The carrying amount of overnight
borrowings approximates fair value.  The fair value of the long-term
borrowings is estimated using a discounted cash flow calculation that applies
current interest rates on similar borrowings with similar terms.
 
 Statement
of Financial Accounting Standards (SFAS) No. 157 defines fair value, establishes
a framework for measuring fair value under generally accepted accounting
principals, and expands disclosures about fair value
measurement.  Effective January 1, 2008 the Company adopted SFAS No.
157, which enhances the disclosures about financial instruments carried at fair
value.  The adoption of SFAS No. 157 did not have an impact on the
Company’s financial condition or results of operations.
 
 Fair
value is a market-based measure considered from the perspective of a market
participant who holds the asset or owes the liability rather than an
entity-specific measure. Therefore, even when market assumptions are not readily
available, the Company’s own assumptions are set to reflect those that market
participants would use in pricing the asset or liability at the measurement
date. The Company uses prices and inputs that are current as of the measurement
date, including during periods of market dislocation, the observability of
prices and inputs may be reduced for many instruments. This condition could
cause an instrument to be reclassified from Level 1 to Level 2 or Level 2 to
Level 3.
   90
 In
general, fair values are determined by:
 
 Level 1
inputs utilize quoted prices (unadjusted) in active markets for identical assets
or liabilities that the Company has the ability to access.
 
 Level 2
inputs include quoted prices for similar assets and liabilities in active
markets, and inputs other than quoted prices that are observable for the asset
or liability, such as interest rates and yield curves that are observable at
commonly quoted intervals.  Fair values determined by Level 2 inputs
utilize inputs other than quoted prices included in Level 1 that are observable
for the asset or liability, either directly or indirectly.
 
 Level 3
inputs are unobservable inputs for the asset or liability, and include
situations where there is little, if any market activity for the asset or
liability.
 
 At
      December 31, 2008Total
                      
                      
                      Level
      1
                      
                      
                      Level
      2
                      
                      
                      Level
      3Available-for-sale
      securities
                      
                      $
                      6,578,924
                      
                      
                      $
                      17,119
                      
                      
                      $
                      6,561,805
                      
                      
                      $
                      0
 
 The
following methods were used to estimate the fair value of each class of
financial instrument above:
 
 Securities
available-for-sale –Securities classified as available-for-sale are
reported at fair value utilizing Level 1 inputs for equity securities and Level
2 inputs for all other investment securities.  For equity securities,
the Company obtains the fair value measurements from NASDAQ and for investment
securities, the Company obtains fair value measurements from an independent
pricing service.  The fair value measurements consider observable data
that may include dealer quotes, market spreads, cash flows, the U.S. Treasury
yield curve, live trading levels, trade execution data, market consensus
prepayment speeds, credit information and the bond’s terms and conditions among
other things.
 
 The
Company may be required, from time to time, to measure certain assets at fair
value on a nonrecurring basis in accordance with U.S. generally accepted
accounting principles.  These include assets that are measured at the
lower of cost or market that were recognized at fair value below cost at the end
of the period.  Assets measured at fair value on a nonrecurring basis
are included in the table below.
  December
      31, 2008Total
                    
                    
                    Level
      1
                    
                    
                    Level
      2
                    
                    
                    Level
      3Impaired
      Loans
                    
                    $
                    9,688,585
                    
                    
                    $
                    0
                    
                    
                    $
                    9,688,585
                    
                    
                    $
                    0Other
      Real Estate Owned
                    
                    $
                    285,665
                    
                    
                    $
                    0
                    
                    
                    $
                    285,665
                    
                    
                    $
                    0
     91
 NOTE
R—FAIR VALUES OF FINANCIAL INSTRUMENTS (Continued)
  Impaired loans
and other real estate owned –The
fair value of impaired loans and other real estate owned is estimated using one
of several methods, including collateral value, market value of similar debt,
enterprise value, liquidation value and discounted cash flows.  Those
impaired loans not requiring an allowance represent loans for which the fair
value of the expected repayments or collateral exceed the recorded investments
in such loans.  At December 31, 2008 substantially all of the total
impaired loans were evaluated based on the fair value of the
collateral.  In accordance with SFAS 157, impaired loans where an
allowance is established based on the fair value of collateral require
classification in the fair value hierarchy.  When the fair value of
the collateral is based on an observable market price or a current appraised
value, the Company records the impaired loan as nonrecurring Level
2.  When an appraised value is not available or management determines
the fair value of the collateral is further impaired below the appraised value
and there is no observable market price, the Company records the impaired loan
as nonrecurring Level 3.
  NOTE
S—SUBSEQUENT EVENTS
  In
November 2008, the Company applied for funds through the U.S. Treasury’s Capital
Purchase Program. On December 17, 2008, we were preliminarily approved to
receive capital in the form of Senior Preferred shares of $8,653,000. This
preliminary approval was pending shareholder approval of a change to our
Articles of Incorporation allowing us to issue preferred shares. On February 11,
2009 shareholder approval was received and the Articles of Incorporation were
amended.  On February 20, 2009, the Company entered into a Letter
Agreement with the United States Department
of the Treasury pursuant to the
Troubled  Asset Relief Program Capital Purchase
Program.  Under the  terms of  the Letter
Agreement,  the Company  issued to the
Treasury,  8,653 shares of senior preferred stock and a warrant to
acquire up to  433.00433 shares of a  separate series of
senior preferred stock for  an aggregate  purchase
price  of $8,653,000, pursuant to the  standard Capital
Purchase Program terms and conditions for  non-public
companies.
  On
February 18, 2009, the Board of Directors declared a cash dividend of $.30 per
share to shareholders of record on February 27, 2009 and payable on March 13,
2009.
  
 ITEM
      9.
              CHANGES
      IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
      DISCLOSURE
 
 None
 
 
 92
 ITEM
9A.                                CONTROLS
AND PROCEDURES.
 
 Disclosure
Controls and Procedures
  Disclosure
controls and procedures are designed with the objective of ensuring that
information required to be disclosed in reports filed by the Company under the
Exchange Act, such as this Annual Report, is recorded, processed, summarized and
reported within the time periods specified in the rules and forms of the
Securities and Exchange Commission. Disclosure controls and procedures are also
designed with the objective of ensuring that such information is accumulated and
communicated to management, including the Chief Executive Officer and the Chief
Financial Officer, as appropriate to allow timely decisions regarding required
disclosure.
  Evaluation
of Disclosure Controls and Procedures and Internal Control over Financial
Reporting
  The
Company carried out an evaluation, under the supervision and with the
participation of management, including the Chief Executive Officer and the Chief
Financial Officer, about the effectiveness of disclosure controls and procedures
pursuant to Exchange Act Rule 13a-15(e). Based upon that evaluation, the Chief
Executive Officer and the Chief Financial Officer concluded that the disclosure
controls and procedures, as of the end of the period covered by this Form 10-K,
are effective in alerting them to material information required to be included
in this Form 10-K.
  Management's
Report on Internal Control over Financial Reporting
  Management
of the Company is responsible for establishing and maintaining adequate internal
control over financial reporting. As defined in Rule 13a-15(f) under the
Exchange Act, internal control over financial reporting is a process designed
by, or under the supervision of, a company's principal executive and principal
financial officers and effected by a company's board of directors, management
and other personnel, to provide reasonable assurance regarding the reliability
of financial reporting and the preparation of financial statements for external
purposes in accordance with generally accepted accounting principles. It
includes those policies and procedures that:
  a)
      Pertain to the maintenance of records that in reasonable detail accurately
      and fairly reflect the transactions and dispositions of the assets of a
      company;
  b)
      Provide reasonable assurance that transactions are recorded as necessary
      to permit preparation of financial statements in accordance with generally
      accepted accounting principles, and that receipts and expenditures of
      a company are being made only in accordance with authorizations of
      management and the board of directors of the company;
  and
  c)
      Provide reasonable assurance regarding prevention or timely detection of
      unauthorized acquisition, use or disposition of a company's assets that
      could have a material effect on its financial
  statements.
  Because
of the inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
  93
 The
Company's management has used the criteria established in "Internal
Control-Integrated Framework" issued by the Committee of Sponsoring
Organizations of the Treadway Commission ("COSO") to evaluate the effectiveness
of the Company's internal control over financial reporting. Management has
selected the COSO framework for its evaluation as it is a control framework
recognized by the SEC and the Public Company Accounting Oversight Board, that is
free from bias, permits reasonably consistent qualitative and quantitative
measurement of the Company's internal controls, is sufficiently complete so that
relevant controls are not omitted, and is relevant to an evaluation of internal
controls over financial reporting.
  Based
on our assessment, management has concluded that our internal control over
financial reporting, based on criteria established in "Internal
Control-Integrated Framework" issued by COSO was effective as of December 31,
2008.
  This
annual report does not include an attestation report of our registered public
accounting firm regarding internal control over financial reporting. Our
management's report was not subject to attestation by our registered public
accounting firm pursuant to temporary rules of the Securities and Exchange
Commission that permit us to provide only our management's report in this annual
report.
 Date:
March 18, 2009
  
 /s/Sean C.
Cutting                                
/s/Mary Dieter
Smith
 Sean C.
Cutting                Mary
Dieter Smith
 Chief
Executive Officer             
Chief Financial Officer
   ITEM
9B.     OTHER INFORMATION.
 
 None
 PART
III
 
 ITEM
10.      DIRECTORS AND EXECUTIVE OFFICERS OF THE
REGISTRANT.
 
 The
information called for in Item 10 of Part III is incorporated by reference from
the definitive proxy statement of the Company to be filed with the Securities
and Exchange Commission within 120 days from fiscal year end.
 
 ITEM
11.      EXECUTIVE COMPENSATION.
 
 The
information called for in Item 11 of Part III is incorporated by reference from
the definitive proxy statement of the Company to be filed with the Securities
and Exchange Commission within 120 days from fiscal year end.
 
 ITEM
      12.
              SECURITY
      OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
      STOCKHOLDER MATTERS.
 
 The
information called for in Item 12 of Part III is incorporated by reference from
the definitive proxy statement of the Company to be filed with the Securities
and Exchange Commission within 120 days from fiscal year end.
 
 94
 ITEM
      13.
              CERTAIN
      RELATIONSHIPS AND RELATED
TRANSACTIONS.
 
 The
information called for in Item 13 of Part III is incorporated by reference from
the definitive proxy statement of the Company to be filed with the Securities
and Exchange Commission within 120 days from fiscal year end.
 
 ITEM
14.    PRINCIPAL ACCOUNTING FEES AND SERVICES.
 
 The
information called for in Item 14 of Part III is incorporated by reference from
the definitive proxy statement of the Company to be filed with the Securities
and Exchange Commission within 120 days from fiscal year end.
  
 PART
IV
 
 ITEM
15.    EXHIBITS, FINANCIAL STATEMENT SCHEDULES.
 
 Financial
Statements
 
 The
following financial statements of the Company are filed as part of this Annual
Report:
  Page
      Number1.
                      Independent
      Auditor's Report
                      
                      542.
                      Consolidated
      Balance Sheets as of December 31, 2008 and
      2007
                      
                      553.
                      Consolidated
      Statements of Operations for the three years ended

                        December
      31, 2008, 2007 and 2006
                      
                      564.
                      Consolidated
      Statements of Changes in Shareholders' Equity

                        for
      the three years ended December 31, 2008, 2007 and 2006
                      
                      57 and
      585.
                      Consolidated
      Statements of Cash Flows for the three years ended

                        December
      31, 2008, 2007 and 2006
                      
                      59 and
      606.
                      Notes
      to Consolidated Financial Statements
                      
                      61
   Financial
Statement Schedules
 
 All other
schedules have been omitted since the required information is not present or is
not present in sufficient amounts to require submission of the schedules or
because the information is included in the financial statements or the notes
thereto.
 
 
 95
 Exhibits
 
 The
following Exhibits are attached or incorporated herein by
reference:
 
 3.1
              Sonoma
      Valley Bancorp Articles of Incorporation, filed as Exhibit 3.1 to the
      Registrant's Registration Statement on Form S-8 filed on June 5,
      2001.
 
 3.3
              Sonoma
      Valley Bancorp By-laws, filed as Exhibit 3.2 to the Registrant's
      Registration Statement on Form S-8 filed on June 5,
  2001.
 
 4.2
              Agreement
      for the sale of Sonoma Valley Bank Stock dated September 23, 1992, filed
      as Exhibit 4.2 (formerly A-1) to the Form F-2 for the year ended December
      31, 1992.
 
 10.1
              Lease
      for Sonoma branch office, filed as Exhibit 10.1 (formerly 7.1) to the
      Registrant's Registration Statement on Form F-1 filed on May 1,
      1989.
 
 10.2
              Sonoma
      Valley Bank Chief Executive Officer Severance Agreement dated January 4,
      1995, filed as Exhibit 10.2 to the Form 10-KSB for the year ended December
      31, 1997.
 
 10.3
              Sonoma
      Valley Bank Supplemental Executive Retirement Plan, as amended on March
      20, 1996, filed as Exhibit 10.3 to the Form 10-KSB for the year ended
      December 31, 1997.
 
 10.4
              Sonoma
      Valley Bank Deferred Compensation Plan, filed as Exhibit 10.4 to the Form
      10-KSB for the year ended December 31,
1997.
 
 10.5
              Sonoma
      Valley Bank Master Trust Agreement for Executive Deferral Plans, filed as
      Exhibit 10.5 to the Form 10-KSB for the year ended December 31,
      1997.
 
 10.6
              Sonoma
      Valley Bank 1996 Stock Option Plan, filed as Exhibit 10.6 to the Form
      10-KSB for the year ended December 31,
1997.
 
 10.7
              Sonoma
      Valley Bank Severance Agreement with Mel Switzer, Jr. dated October 21,
      1998, filed as Exhibit 10.7 to the From 10-KSB for the year ended December
      31, 1998.
 
 10.8
                Sonoma
      Valley Bank Severance Agreement with Mary Dieter dated October 21, 1998,
      filed as Exhibit 10.8 to the From 10-KSB for the year ended December 31,
      1998.10.10
                Sonoma
      Valley Bancorp Assumption of Severance Agreement [Form of], filed as
      Exhibit 10.1 to the Form 10-KSB for the year ended December 31,
      2001.10.11
                Sonoma
      Valley Bancorp 2002 Equity Incentive Plan, filed as Exhibit A to the
      Company’s Proxy Statement for the Annual Meeting held on May 14,
      2002.10.12
                Sonoma
      Valley Bank Severance Agreement with Sean Cutting dated March 18, 2004,
      filed as Exhibit 10.12 to the Form 10-K for the year ended December 31,
      2003.
  23.1
              Consent
      of Richardson and Co., Independent
Auditors.
 
 31.1
              Certification
      of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act
 
 31.2
              Certification
      of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act
 
 32
              Certification
      of Chief Executive Officer and Chief Financial Officer pursuant to Section
      906 of the Sarbanes-Oxley Act
 
 96
 
 SIGNATURES
 
 Pursuant
to the requirements of Section 13 or 15(d) of the Securities Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
 
 SONOMA
VALLEY BANCORP,
 A
California corporation
 
 
 /s/ Sean C.
Cutting.                                                                                                 March
18, 2009
 Sean C.
Cutting,
 President
and
 Chief
Executive Officer
 (Principal
Executive Officer)
 
  /s/ Mary Dieter
Smith                                                                                                         March
18, 2009
 Mary
Dieter Smith,
 Executive
Vice President and
 Chief Financial
Officer
 (Principal
Finance and Accounting Officer)
 
 In
accordance with the Exchange Act, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the
dates indicated.
 
  /s/ Suzanne
Brangham                                                                                                 March 18,
2009
 Suzanne
Brangham, Secretary
 of the
Board and Director
 
  /s/ Dale T.
Downing                                                                                                 March
18, 2009
 Dale T.
Downing, Director
 
  /s/ Robert B.
Hitchcock                                                                                                     
March 18, 2009
 Robert B.
Hitchcock, Director
 
 
 /s/ Robert J.
Nicholas                                                                                                         March
18, 2009
 Robert J.
Nicholas, Chairman
 of the
Board and Director




/s/ Valerie
Pistole                                                                                                March 18, 2009
 Valerie
Pistole, Director
 
 97
 
 /s/ Mel Switzer,
Jr.                                                                                              March
18, 2009
 Mel
Switzer, Jr., Vice-Chairman
 of the
Board and Director
 
 
 /s/ Sean C.
Cutting.                                                                                             March
18, 2009
 Sean C.
Cutting,
 President
and
 Chief
Executive Officer
 (Principal
Executive Officer)
 
 
 /s/ Mary Dieter
Smith                                                                                          March
18, 2009
 Mary
Dieter Smith,
 Executive
Vice President
and
 Chief
Financial Officer
 (Principal Finance
and Accounting Officer)
 
 98