**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**WASHINGTON,
      DC 20549**


**_____________________**




**FORM
      10-QSB**


**_____________________**





**QUARTERLY
      REPORT UNDER SECTION 13 OR 15(d)**




**OF
      THE SECURITIES EXCHANGE ACT OF 1934**




For
      the
      quarterly period ended September 30, 2006




Commission
      File Number: 333-122090




**_____________________**




**DISCOVERY
      BANCORP**




(Name
      of
      Small Business Issuer as Specified in its Charter)




**_____________________**




**California**
              (State
                or other jurisdiction
              of
                incorporation or organization)
            
            **20-1814766**
              (I.R.S.
                Employee
              Identification
                No.)





**338
                Via Vera Cruz, San Marcos, California 92078**(Address
                of Principal Executive Offices) (Zip Code)**(760)
                736-8900**(Issuer’s
                Telephone Number including Area
                Code)





**_____________________**







Check
      whether the issuer: (1) filed all reports required to be filed by Section 13
      or
      15(d) of the Exchange Act during the past 12 months (or for such shorter period
      that the registrant was required to file such reports), and (2) has been subject
      to such filing requirements for the past 90 days.




Yes
              x
            Noo




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




Yes
              o
            Nox




As
      of
      November 10, 2006, 1,895,234 shares of the issuer’s common stock were
      outstanding.




Transitional
      Small Business Disclosure Format (Check one):




Yes
              o
            Nox












TABLE
      OF CONTENTS


PART
                  I — FINANCIAL INFORMATIONITEM
                1. FINANCIAL STATEMENTSITEM
                2. MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLAN OF
                OPERATIONITEM
                3. CONTROLS AND PROCEDURESPART
                  II — OTHER INFORMATIONITEM
                1. LEGAL PROCEEDINGSITEM
                2. UNREGISTERED SALES OF EQUITY SECURITIES AND
                USE OF PROCEEDSITEM
                3. DEFAULTS UPON SENIOR
                SECURITIESITEM
                4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY
                HOLDERSITEM
                5. OTHER INFORMATIONITEM
                  6. EXHIBITSSIGNATURESExhibit
                  31.1Exhibit
                  31.2Exhibit
                  32.1







PART
        I — FINANCIAL INFORMATION


**ITEM
      1. FINANCIAL STATEMENTS**




**DISCOVERY
      BANCORP AND SUBSIDIARIES**


**CONSOLIDATED
      BALANCE SHEETS**


**SEPTEMBER
      30, 2006 AND DECEMBER 31, 2005**





(dollars
                in thousands)**September
                30,**
              **2006**
            
            
            **December
                31,**
              **2005********ASSETS**
            
            
            (unaudited)Cash
                & due from banks
            
            $
            7,131
            
            $
            6,709Fed
                Funds sold
            
            
            14,140
            
            
            8,145Cash
                and cash equivalents
            
            
            21,271
            
            
            14,854Interest-bearing
                deposits at banks
            
            
            5,644
            
            
            2,606Investment
                securities available-for-sale
            
            
            3,010
            
            
            3,402Common
                stock, substantially restricted
            
            
            956
            
            
            648Loans,
                  net of allowance for loan losses of$2,058
                in 2006 and $1,784 in 2005
            
            
            154,437
            
            
            134,326Goodwill
            
            
            1,731
            
            
            1,731Accrued
                interest receivable and other assets
            
            
            1,556
            
            
            1,127Premises
                and equipment, net
            
            
            5,782
            
            
            6,012**TOTAL
                ASSETS**
            
            $
            194,387
            
            $
            164,706**LIABILITIES**DepositsNon-interest-bearing
                demand
            
            $
            21,681
            
            $
            21,569Interest-bearing
                demand
            
            
            36,326
            
            
            28,560Savings
            
            
            1,718
            
            
            1,987Time,
                under $100,000
            
            
            39,933
            
            
            28,032Time,
                $100,000 and over
            
            
            34,406
            
            
            32,437Total
                deposits
            
            
            134,064
            
            
            112,585Borrowings
                under line of credit
            
            
            15,509
            
            
            16,086Overnight
                borrowings - FHLB
            
            
            19,065
            
            
            12,000Accrued
                interest payable and other liabilities
            
            
            1,260
            
            
            1,192**TOTAL
                LIABILITIES**
            
            $
            169,898
            
            $
            141,863**STOCKHOLDERS’
                EQUITY**Common
                stock, no par value; authorized 10,000,000 shares,
              issued
                and outstanding 1,881,398 and 1,871,883 shares at
              September
                30, 2006 and December 31, 2005 respectively
            
            $
            22,998
            
            $
            22,776Retained
                earnings
            
            
            1,524
            
            
            106Accumulated
                other comprehensive loss
            
            
            (33
            )
            
            (39
            )**TOTAL
                STOCKHOLDERS’ EQUITY**
            
            
            24,489
            
            
            22,843**TOTAL
                LIABILITIES AND STOCKHOLDERS’ EQUITY**
            
            $
            194,387
            
            $
            164,706




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












**DISCOVERY
      BANCORP AND SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF INCOME (UNAUDITED)**


**FOR
      THE PERIODS ENDED SEPTEMBER 30, 2006 AND 2005**




(Dollar
                amounts in thousands, except per share amounts)**Three
                Months Ended**
              **September
                30,**
            
            **Nine
                Months Ended**
              **September****30,****2006**
            
            
            **2005**
            
            
            **2006**
            
            
            **2005****INTEREST
                INCOME**Interest
                and fees on loans
            
            $
            4,152
            
            $
            2,531
            
            $
            11,834
            
            $
            6,019Interest
                on federal funds sold
            
            
            133
            
            
            88
            
            
            336
            
            
            187Interest
                on securities
            
            
            40
            
            
            39
            
            
            124
            
            
            109Other
            
            
            66
            
            
            26
            
            
            170
            
            
            61**TOTAL
                INTEREST INCOME**
            
            
            4,391
            
            
            2,684
            
            
            12,464
            
            
            6,376**INTEREST
                EXPENSE**Deposits
            
            
            1,224
            
            
            686
            
            
            3,210
            
            
            1,747Borrowings
                under line of credit
            
            
            316
            
            
            76
            
            
            905
            
            
            76Overnight
                borrowings - FHLB
            
            
            137
            
            
            103
            
            
            377
            
            
            228Other
            
            
            0
            
            
            3
            
            
            0
            
            
            9**TOTAL
                INTEREST EXPENSE**
            
            
            1,677
            
            
            868
            
            
            4,492
            
            
            2,060**NET
                INTEREST INCOME**
            
            
            2,714
            
            
            1,816
            
            
            7,972
            
            
            4,316**PROVISION
                FOR LOAN LOSSES**
            
            
            113
            
            
            350
            
            
            336
            
            
            633**NET
                INEREST INCOME AFTER PROVISION FOR LOAN LOSSES**
            
            
            2,601
            
            
            1.466
            
            
            7,636
            
            
            3,683**NON
                - INTEREST INCOME**Customer
                service fees & charges
            
            
            43
            
            
            54
            
            
            122
            
            
            94Gain
                on sale of SBA loans
            
            
            46
            
            
            0
            
            
            213
            
            
            123Rental
                income (loss), net
            
            
            (35
            )
            
            33
            
            
            117
            
            
            180Other
                loan fees & charges
            
            
            170
            
            
            64
            
            
            392
            
            
            152**TOTAL
                NON - INTEREST INCOME**
            
            
            224
            
            
            151
            
            
            844
            
            
            549**NON
                - INTEREST EXPENSE**Salaries
                and employee benefits
            
            
            1,259
            
            
            817
            
            
            3,671
            
            
            1,940Net
                occupancy
            
            
            130
            
            
            107
            
            
            392
            
            
            240Furniture
                and equipment
            
            
            72
            
            
            80
            
            
            226
            
            
            220Data
                processing
            
            
            97
            
            
            139
            
            
            289
            
            
            239Advertising
            
            
            63
            
            
            30
            
            
            160
            
            
            82Professional
            
            
            190
            
            
            342
            
            
            559
            
            
            719Office
                supplies
            
            
            16
            
            
            18
            
            
            59
            
            
            53Other
                operating
            
            
            212
            
            
            49
            
            
            636
            
            
            354**TOTAL
                NON - INTEREST EXPENSE**
            
            
            2,039
            
            
            1,582
            
            
            5,992
            
            
            3,847**INCOME
                BEFORE INCOME TAXES**
            
            
            786
            
            
            35
            
            
            2,488
            
            
            385**INCOME
                TAX PROVISION**
            
            
            340
            
            
            22
            
            
            1,070
            
            
            162**NET
                INCOME**
            
            $
            446
            
            $
            13
            
            $
            1,418
            
            $
            223Basic
                earnings per share
            
            $
            0.24
            
            $
            0.01
            
            $
            0.76
            
            $
            0.20Diluted
                earnings per share
            
            $
            0.23
            
            $
            0.01
            
            $
            0.73
            
            $
            0.19




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












**DISCOVERY
      BANCORP**  **AND
      SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (UNAUDITED)**


**FOR
      THE NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005**








(Dollars
                in thousands)**Common**
                **Shares****Outstanding**
            
            
            **Amount**
            
            
            **Paid
                    Stock****Subscriptions****Amount**
            
            
            **Retained**
                **Earnings**
                **Accumulated****Deficit**
            
            
            Accumulated
                  Other
                **Comprehensive****Loss**
            
            
            **Total**
                  Stockholders’**Equity****Balance,**January 1,
                2005
            
            
            1,037,498
            
            $
            10,756
            
            $
            —
            
            $
            (447
            )
            $
            (10
            )
            $
            10,299Comprehensive
                income:Net
                income
            
            
            
            
            
            
            
            
            
            
            
            223
            
            
            
            
            
            223Unrealized
                losses on investment securities
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (22
            )
            
            (22
            )Total
                comprehensive income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            201Stock
                issued as part of Celtic asset purchase
            
            
            53,613
            
            
            831
            
            
            
            
            
            
            
            
            
            
            
            831Stock
                issued as part of offering
            
            
            580,265
            
            
            8,138
            
            
            
            
            
            
            
            
            
            
            
            8,138Paid
                stock subscriptions-shares not issued
            
            
            
            
            
            
            
            
            3
            
            
            
            
            
            
            
            
            3,000Warrants
                exercised
            
            
            250
            
            
            4
            
            
            
            
            
            
            
            
            
            
            
            4Repurchase
                of organizational shares issued
            
            
            (200
            )
            
            (2
            )
            
            
            
            
            
            
            
            
            
            
            (2
            )**Balance,**September
                30, 2005
            
            
            1,671,426
            
            $
            19,727
            
            $
            3
            
            $
            (224
            )
            $
            (32
            )
            $
            22,471**Balance,**January 1,
                2006
            
            
            1,871,883
            
            $
            22,776
            
            $
            —
            
            $
            106
            
            $
            (39
            )
            $
            22,843Comprehensive
                income:Net
                income
            
            
            
            
            
            
            
            
            
            
            
            1,418
            
            
            
            
            
            1,418Unrealized
                losses on investment securities
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            6
            
            
            6Total
                comprehensive income
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            1,424Compensation
                expense on incentive stock options
            
            
            
            
            
            119
            
            
            
            
            
            
            
            
            
            
            
            119Warrants
                exercised, net of costs of $39,536
            
            
            9,515
            
            
            103
            
            
            
            
            
            
            
            
            
            
            
            103**Balance,**September
                30, 2006
            
            
            1,881,398
            
            $
            22,998
            
            $
            —
            
            $
            1,524
            
            $
            (33
            )
            $
            24,489





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












**DISCOVERY
      BANCORP AND SUBSIDARIES**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**


**FOR
      THE NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005
      (UNAUDITED)**





(dollars
                in thousands)**September
                30,**
              **2006**
            
            
            **September
                30,**
              **2005****CASH
                FLOWS FROM OPERATING ACTIVITIES:**Net
                income
            
            $
            1,418
            
            $
            223Adjustments
                to reconcile net income to net cash provided by operating activities:Provision
                for loan losses
            
            
            336
            
            
            633Depreciation
                and amortization
            
            
            341
            
            
            306Amortization
                of deferred loan fees
            
            
            (128
            )
            
            (168
            )Compensation
                expense on stock options
            
            
            119
            
            
            0Change
                in:Deferred
                tax assets
            
            
            (115
            )
            
            138Accrued
                interest receivable and other assets
            
            
            (314
            )
            
            (301
            )Accrued
                interest payable and other liabilities
            
            
            68
            
            
            760Net
                cash provided by operating activities
            
            
            1,725
            
            
            1,591**CASH
                FLOWS FROM INVESTING ACTIVITIES:**Purchases
                of premises and equipment
            
            
            (111
            )
            
            (388
            )Net
                change in interest bearing deposits at banks
            
            
            (3,038
            )
            
            (308
            )Purchase
                of common stock substantially restricted
            
            
            (308
            )
            
            (146
            )Sales,
                maturities and paydowns of securities available-for-sale
            
            
            398
            
            
            936Purchases
                of securities available-for-sale
            
            
            —
            
            
            (1,751
            )Net
                change in loans
            
            
            (20,319
            )
            
            (31,112
            )Net
                cash used for purchase of Celtic Capital Corporation
            
            
            0
            
            
            (3,698
            )Net
                cash used for investing activities
            
            
            (23,378
            )
            
            (36,467
            )**CASH
                FLOWS FROM FINANCING ACTIVITIES:**Proceeds
                from borrowings under line of credit, net of repayments
            
            
            (577
            )
            
            1,763Proceeds
                from overnight borrowings FHLB, net of repayments
            
            
            7,065
            
            
            3,000Proceeds
                from warrants exercised
            
            
            103
            
            
            4Repurchase
                of organizational shares issued
            
            
            0
            
            
            (2
            )Proceeds
                from issuance of common stock, net of capital raising
                costs
            
            
            
            
            
            11,138Net
                change in deposits
            
            
            21,479
            
            
            29,544Net
                cash provided by financing activities
            
            
            28,070
            
            
            45,447Increase
                in cash and cash equivalents
            
            
            6,417
            
            
            10,571**CASH
                AND CASH EQUIVALENTS BALANCE**Beginning
                of period
            
            
            14,854
            
            
            6,584End
                of period
            
            $
            21,271
            
            $
            17,155**Supplemental
                Disclosures of Cash Flow Information**Cash
                paid during the year for:Interest
            
            $
            4,456
            
            $
            1,955Income
                taxes
            
            $
            1,493
            
            $
            20




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









**DISCOVERY
      BANCORP AND SUBSIDIARIES**





**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**NOTE
      1 - OPERATIONS, BASIS OF PRESENTATION AND STOCK BASED
      COMPENSATION**





**Nature
      of Operations** -
      Discovery Bancorp (the “Company”) is the holding company for Discovery Bank (the
“Bank”), headquartered in San Marcos, California, and Celtic Capital Corporation
      (“Celtic”), headquartered in Santa Monica, California. On June 22, 2005,
      the Company acquired ownership of the Bank through a corporate reorganization
      and became a bank holding company registered under the Bank Holding Company
      Act
      of 1956, as amended.




The
      Bank,
      through its wholly owned subsidiary, San Marcos Building, LLC, owns a
      28,000-square-foot, two story commercial building to house the Bank’s corporate
      offices and head branch location. The Bank occupies approximately 13,500 square
      feet with the remaining spaces leased to third parties on a short-term basis.
      Net rental income activity for the three months ended September 30, 2006 totaled
      a loss of $35 thousand and for the nine months ended September 30, 2006 totaled
      $117 thousand and is reflected as other income within the consolidated financial
      statements.





On
      August
      31, 2005, the Company, through its wholly owned subsidiary, Celtic Merger Corp.,
      acquired certain assets and assumed certain liabilities of Celtic Capital
      Corporation, a commercial finance lender. $19.3 million of commercial loans
      and
      other assets, including $1.7 million of goodwill established as part of the
      purchase, were acquired. Funding for the purchase was provided by a borrowing
      line established with an unaffiliated bank, $5.2 million in cash and 53,613
      shares of the Company’s common stock. Celtic Merger Corp. has been renamed
      Celtic Capital Corporation (“Celtic”) and operates as a commercial finance
      lender. As a commercial finance lender, Celtic makes “asset-based” loans to
      companies that do not qualify for bank credit and secures its loans with
      business assets, such as accounts receivable, equipment and inventory. The
      Company’s financial statements include the accounts of Celtic since the date of
      acquisition.





Further,
      at September 30, 2005, the Company had largely completed a $12.8 million public
      stock offering, and had received proceeds, net of underwriting costs, of
      approximately $11.1 million. On November 8, 2005, the Company closed its public
      offering registered on Form SB-2 and issued a total of 827,425 shares ($12.8
      million) of its common stock. 53,613 of these shares ($831 thousand) were issued
      to principals of Celtic on August 31, 2005 as part of the Celtic asset
      acquisition.





**Basis
      of Presentation** - The
      accompanying unaudited consolidated financial statements have been prepared
      in
      accordance with accounting principles generally accepted in the United States
      of
      America.




On
      June 22, 2005, all of the outstanding shares of the Bank were converted
      into shares of Discovery Bancorp. The consolidated financial statements for
      the
      period ending September 30, 2006 include the Company, the Bank, the Bank’s
      premises subsidiary, and Celtic. All significant inter-company balances and
      transactions have been eliminated in consolidation. The consolidated financial
      statements as of September 30, 2005 are derived from the company’s unaudited
      consolidated financial statements. These consolidated financial statements
      should be reviewed in conjunction with the consolidated financial statements
      and
      notes thereto included in the Company’s Annual Report on Form 10-KSB filed with
      the Securities and Exchange Commission, as amended. In the opinion of
      management, all adjustments, consisting of normal recurring accruals considered
      necessary for a fair presentation of the financial statements, have been
      included.





**Reclassifications** - Certain
      prior year amounts have been reclassified to conform to the current year
      presentation.




**Stockholder’s
      Equity and Stock Based Compensation** - **** The
      Company has a stock option plan (hereinafter the “Plan”) which provides for
      non-qualified stock options for non-employee directors and incentive stock
      options for employees to purchase up to a maximum of 500,000 shares of
      authorized common stock. Pursuant to the Plan, the Company has awarded options
      to directors and employees. The options granted vest 20% per year over five
      years from the grant date and expire ten years after grant. As of September
      30,
      2006, 6,910 options had been exercised since the inception of the Plan. As
      of
      September 30, 2006 the Company had options outstanding to purchase a total
      of
      246,457 shares of common stock, at exercise prices ranging from $10.00 per
      share
      to $18.15 per share, leaving 246,633 shares available for future
      grants.





Prior
      to
      January 1, 2006, the Company accounted for its stock options under the
      recognition and measurement principles of Accounting Principles Board (APB)
      Opinion No. 25, *Accounting
      for Stock Issued to Employees* (APB
      No.
      25), and related interpretations. Accordingly, no stock based employee
      compensation cost was reflected in net earnings prior to January 1, 2006 as
      all
      options to purchase common stock of the Company had an exercise price equal
      to,
      or greater than, the market value of the underlying common stock on the date
      of
      grant.









Effective
      January 1, 2006, the Company began recording compensation expense associated
      with stock-based awards in accordance with Statement of Financial Accounting
      Standards (SFAS) No. 123 (revised 2004), *Share-Based
      Payment* (SFAS
      No.
      123R) as interpreted by SEC Staff Accounting Bulletin No. 107. SFAS No. 123R
      supercedes APB No. 25, and amends SFAS No. 95 *Statement
      of Cash Flows* .
      Generally, the approach in SFAS No. 123R is similar to the approach described
      in
      SFAS No. 123, *Accounting
      for Stock-Based Compensation* (SFAS
      No.
      123). However, SFAS No. 123R requires all stock-based payments to employees,
      including grants of employee stock options, to be recognized in the income
      statement based on their fair values at the date of grant. The stock-based
      compensation expense amount recorded was $41 thousand (pre-tax amount) for
      the
      three months ended September 30, 2006 and $119 thousand (pre-tax amount) for
      the
      nine months ended September 2006.





The
      following table illustrates the effect on net earnings and earnings per share
      if
      the Company had applied the fair value recognition provisions of SFAS No. 123
      in
      the previous year:


****


**Three Months
                ended**
              **September****30, 2005**
            
            
            
            **Nine
                Months ended**
              **September****30, 2005**(dollars
                in thousands)Reported
                net earnings
            
            $
            13
            
            
            $
            223Stock-based
                employee compensation expense, net of related tax effects
            
            
            (30
            )
            
            
            (92
            )Pro
                forma net earnings
            
            $
            (17
            )
            
            $
            131Basic
                net earnings per shareAs
                Reported
            
            $
            0.01
            
            
            $
            0.20Pro
                Forma
            
            $
            (0.01
            )
            
            $
            0.12Diluted
                net earnings per shareAs
                Reported
            
            $
            0.01
            
            
            $
            0.19Pro
                Forma
            
            $
            (0.01
            )
            
            $
            0.11




The
      fair value of each option granted is estimated on the date of grant using the
      Black-Scholes option-pricing model. The Company uses the following input
      variables as of the grant date, to arrive at the fair value for each grant:




1)
            Grant
              date;2)
            Options
              granted;3)
            Exercise
              price;4)
            Stock
              price on date of grant;5)
            Expected
              dividend rate;6)
            Expected
              volatility;7)
            Risk
              free interest rate on grant date;8)
            Expected
              term; and9)
            Expected
              forfeiture rate.












**NOTE
      2 - RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS**








In
      September 2006, the FASB issued SFAS No. 157, “ *Fair
      Value Measurements* ,”
which
      defines fair value, establishes a framework for measuring fair value, and
      expands disclosures about fair value measurements. SFAS No. 157 does not
      require any new fair value measurements, but applies under other existing
      accounting pronouncements that require or permit fair value measurements. SFAS
      No. 157 emphasizes that fair value is a market-based measurement, not an
      entity-specific measurement and, therefore, should be determined based on the
      assumptions that market participants would use in pricing that asset or
      liability. SFAS No. 157 also establishes a fair value hierarchy that
      distinguishes between market participant assumptions developed based on market
      data obtained from independent sources and the Company’s own assumptions about
      market participant assumptions based on the best information available. SFAS
      No. 157 is effective for the Company on January 1, 2008 with earlier
      adoption permitted. The Company does not expect adoption to have a significant
      impact on the consolidated financial statements, results of operations or
      liquidity of the Company.





In
      September 2006, the FASB issued SFAS No. 158, “ *Employers’
      Accounting for Defined Benefit Pension and Other Postretirement Plans—an
      amendment of FASB Statements No. 87, 88, 106 and 132(R)* .”
SFAS
      No. 158 requires employers to recognize the over funded or under funded
      status of defined benefit postretirement plans, other than multiemployer plans,
      as assets or liabilities on the balance sheet and to recognize changes in the
      funded status in the year in which the changes occur through comprehensive
      income. The recognition and disclosure provisions of SFAS No. 158 are
      effective for the Company as of December 31, 2006. The Company does not
      expect adoption of SFAS No. 158 to have a significant impact on the
      consolidated financial statements, results of operations or liquidity of the
      Company.




In
      June
      2006, the Financial Accounting Standards Board (the "FASB") issued FASB
      Interpretation No. 48 *Accounting
      for Uncertainty in Income Taxes* (an
      interpretation of FASB Statement No. 109) which is effective for fiscal years
      beginning after December 15, 2006 with earlier adoption encouraged. This
      interpretation was issued to clarify the accounting for uncertainty in income
      taxes recognized in the financial statements by prescribing a recognition
      threshold and measurement attribute for the financial statement recognition
      and
      measurement of a tax position taken or expected to be taken in a tax return.
      Management is currently evaluating the potential impact of this
      interpretation.




In
      March 2006, SFAS No. 156, *Accounting
      for Servicing of Financial Assets—an Amendment of FASB Statement
      No. 140* ,
      was
      issued. SFAS No. 156 requires recognition of a servicing asset or liability
      at fair value each time an obligation is undertaken to service a financial
      asset
      by entering into a servicing contract. SFAS No. 156 also provides guidance
      on subsequent measurement methods for each class of servicing assets and
      liabilities and specifies financial statement presentation and disclosure
      requirements. SFAS No. 156 is effective for fiscal years beginning after
      September 15, 2006. The Company is currently evaluating the impact of
      adopting SFAS No. 156 on its consolidated financial position, results of
      operations and cash flows.




At
      September 30, 2006 the Company had no changes in accounting
      principles.









**NOTE
      3 - EARNINGS PER SHARE (EPS)**




Basic
      earnings per share represent income available to common shareholders divided
      by
      the weighted-average number of common shares outstanding during the period.
      Diluted earnings per share reflects additional common shares that would have
      been outstanding if dilutive potential common shares had been issued, as well
      as
      any adjustment to income that would result from the assumed issuance. Potential
      common shares that may be issued by the Company relate to outstanding stock
      options and warrants, and are determined using the treasury stock
      method.








The
      following is a reconciliation of basic EPS to diluted EPS for the three months
      ended September 30, 2006 and 2005:








**Earnings
                per share calculation**
              **For
                the three months ended September 30,**(Dollar
                amounts in thousands, except per share amounts)**2006**
            
            **2005****Net**
              **Income**
            
            **Weighted**
              **Average**
              **Shares**
              **Outstanding**
            
            **Per**
              **Share**
              **Amount**
            
            **Net**
              **Income**
            
            **Weighted**
              **Average**
              **Shares**
              **Outstanding**
            
            **Per**
              **Share**
              **Amount**Basic
                EPS:Income
                available to common shareholders
            
            $
            446
            
            
            1,875
            
            $
            0.24
            
            $
            13
            
            
            1,304
            
            $
            0.01Effect
                of dilutive securities:Stock
                options/warrants
            
            
            —
            
            
            60
            
            
            (0.01
            )
            
            —
            
            
            59Diluted
                EPS:Income
                available to common shareholders
            
            $
            446
            
            
            1,935
            
            $
            0.23
            
            $
            13
            
            
            1,362
            
            $
            0.01







The
      following is a reconciliation of basic EPS to diluted EPS for the nine months
      ended September 30, 2006 and 2005:


**Earnings
                  per share calculation**
                **For
                  the nine months ended September 30,**(Dollar
                  amounts in thousands, except per share amounts)**2006**
              
              **2005****Net**
                **Income**
              
              **Weighted**
                **Average**
                **Shares**
                **Outstanding**
              
              **Per**
                **Share**
                **Amount**
              
              **Net**
                **Income**
              
              **Weighted**
                **Average**
                **Shares**
                **Outstanding**
              
              **Per
                  Share**
                **Amount**Basic
                  EPS:Income
                  available to common shareholders
              
              $
              1,418
              
              
              1,873
              
              $
              0.76
              
              $
              223
              
              
              1,121
              
              $
              0.20Effect
                  of dilutive securities:Stock
                  options/warrants
              
              
              —
              
              
              60
              
              
              (0.03
              )
              
              —
              
              
              60
              
              
              (0.01
              )Diluted
                  EPS:Income
                  available to common shareholders
              
              $
              1,418
              
              
              1,933
              
              $
              0.73
              
              $
              223
              
              
              1,181
              
              $
              0.19






**NOTE
      4 - BORROWINGS**





The
      Bank
      has a continuous revolving line of credit with the Federal Home Loan Bank (FHLB)
      providing for working capital advances up to $29 million. Borrowings are payable
      on demand and are fully collateralized by certain Bank assets. Interest on
      outstanding borrowings accrues at the rates negotiated at the time of borrowing
      which ranged from 5.41% to 5.47% during the third quarter 2006. The Bank had
      $19.1 million outstanding against the line as of September 30, 2006 at a rate
      of
      5.47%. The Bank had $12.0 million outstanding against the line as of December
      31, 2005.




The
      Bank
      has an unsecured line of credit with Pacific Coast Bankers Bank (PCBB) providing
      for federal fund purchases up to $2.5 million. Interest on outstanding
      borrowings accrues at the PCBB daily fed fund rate. The Bank had no outstanding
      borrowings against the line as of September 30, 2006 and December 31, 2005.





Celtic
      has
      a $25 million revolving line-of-credit with a non-affiliated bank. The
      line-of-credit matures in August 2008. The agreement provides for the bank
      to advance funds up to the maximum line of credit, provided the total amount
      of
      outstanding advances at any time does not exceed the “Borrowers’ Borrowing Base”
(BBB). The BBB is based on a percentage of the Celtic’s good quality accounts
      receivable, equipment and inventory, pledged to it by its debtors. The line
      of
      credit is subject to covenants requiring Celtic to meet certain leverage and
      net
      worth ratios and contains restrictions as to the incurrence of additional debt,
      capital expenditures and payment of dividends. Celtic was in compliance with
      all
      covenants as of September 30, 2006. Principal is payable on demand, and interest
      is payable monthly at prime minus 0.25%. The outstanding balance under this
      revolving line of credit was $15.5 million at September 30, 2006 and $16.1
      million at December 31, 2005. The underlying loans serve as collateral for
      the
      borrowings.








**NOTE
      5 - PURCHASE OF ASSETS AND LIABILITIES**





On
      August
      31, 2005, the Company, through its wholly-owned subsidiary (Celtic Merger
      Corp.), acquired the assets and certain liabilities of Celtic Capital
      Corporation for a purchase price of $5.2 million in cash and the issuance of
      53,613 shares of the Company’s common stock to the principals of Celtic. The
      value of the stock was determined to be $15.50 per share at the time of the
      acquisition. The source of funds for the acquisition was available cash,
      primarily from the partially completed August, 2005 $12.8 million common stock
      offering. Celtic Merger Corp. assumed the premises leases of Celtic Capital
      Corporation’s two offices. Celtic Merger Corp., as part of the asset purchase,
      also entered into certain employment and consulting agreements with principals
      of Celtic Capital Corporation. Celtic Merger Corp. was renamed Celtic Capital
      Corporation ("Celtic").




The
      acquisition was accounted for using the purchase method of accounting and,
      accordingly, Celtic’s results of operations have been included in the
      consolidated financial statements since the date of acquisition. The following
      table summarizes the estimated fair value of the assets acquired and liabilities
      assumed at the date of acquisition:







Assets
                acquired:
            
            (dollars
                in thousands)Cash
            
            $
            1,529Loans
            
            
            15,966Goodwill
            
            
            1,731Other
                assets
            
            
            98Total
                assets acquired
            
            $
            19,324Liabilities
                assumed:Borrowing
                under line of credit
            
            $
            13,214Other
                liabilitiesTotal
                liabilities assumed
            
            $
            13,267







Goodwill
      of $1.7 million represents the excess of purchase price paid over the estimated
      fair values of the assets acquired, net of the liabilities assumed. Goodwill
      is
      not amortized, but is evaluated for possible impairment at least annually and
      more frequently if events and circumstances indicate that the asset might be
      impaired. No impairment losses were recognized in connection with goodwill
      during the period ending September 30, 2006.












**NOTE
      6 — FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET RISK**





The
      Company is a party to financial instruments with off-balance-sheet risk in
      the
      normal course of business to meet the financing needs of its customers and
      to
      reduce its own exposure to fluctuations in interest rates. These financial
      instruments include commitments to extend credit, standby letters of credit
      and
      financial guarantees. Those instruments involve, to varying degrees, elements
      of
      credit and interest rate risk in excess of the amount recognized in the balance
      sheet. The contract or notional amounts of those instruments reflect the extent
      of the Company’s involvement in particular classes of financial
      instruments.





The
      Company’s exposure to credit loss in the event of nonperformance by the other
      party to the financial instrument for commitments to extend credit, standby
      letters of credit, and financial guarantees written is represented by the
      contractual notional amount of those instruments. The Company uses the same
      credit policies in making commitments and conditional obligations as it does
      for
      on-balance sheet instruments.





At
      September 30, 2006 and December 31, 2005, the following financial instruments
      were outstanding whose contract amounts represent credit risk:






(dollars
                in thousands)**September
                30,**
              **2006**
            
            
            **December
                31,**
              **2005**Unfunded
                commitments under lines of credit
            
            $
            46,343
            
            $
            38,626Commercial
                and standby letters of credit
            
            $
            800
            
            $
            566








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. Since many of the commitments are expected to expire
      without being drawn upon, the total commitment amounts do not necessarily
      represent future cash requirements.





Standby
      letters of credit are conditional commitments issued by the Company to guarantee
      the performance of a customer to a third party. Those letters of credit are
      primarily issued to support public and private borrowing arrangements. All
      standby letters of credit issued by the Company expire within one year of
      issuance. The credit risk involved in issuing letters of credit is essentially
      the same as that involved in extending loan facilities to customers. The Company
      generally holds collateral supporting those commitments, if deemed
      necessary.




Lines
      of
      credit and commercial and standby letters of credit are variable rate loans
      generally tied to the prime rate or other variable indexes.






**ITEM
        2. MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLAN OF
        OPERATION**








**Introduction** **.**





Discovery
      Bancorp (the “Company”) is the holding company for Discovery Bank (the “Bank”),
      headquartered in San Marcos, California, and Celtic Capital Corporation,
      headquartered in Santa Monica, California. On June 22, 2005, the Company
      acquired ownership of the Bank through a corporate reorganization and became
      a
      bank holding company registered under the Bank Holding Company Act of 1956,
      as
      amended.





On
      August
      31, 2005, the Company, through its wholly owned subsidiary, Celtic Merger Corp.,
      acquired certain assets and assumed certain liabilities of Celtic Capital
      Corporation, a commercial finance lender. $19.3 million of commercial loans
      and
      other assets, including $1.7 million of goodwill established as part of the
      purchase, were acquired. Funding for the purchase was provided by a borrowing
      line established with an unaffiliated bank, $5.2 million in cash and 53,613
      shares of the Company common stock. Celtic Merger Corp. assumed the premises
      leases of Celtic’s two offices. Celtic Merger Corp. has been renamed Celtic
      Capital Corporation (“Celtic”) and continues to operate as a commercial finance
      lender. As a commercial finance lender, Celtic makes “asset-based” loans to
      companies that do not qualify for bank credit and secures its loans with
      business assets, such as accounts receivable and inventory. Because the business
      conducted by Celtic is the same as that previously conducted by Celtic Capital
      Corporation, the Company has caused Celtic to enter into employment agreements
      and/or consulting agreements with the Celtic Capital Corporation principals,
      Mark Hafner, who serves as President and Chief Executive Officer of Celtic;
      Alex
      Falo, who serves as Vice President and Loan Manager of Celtic; and Bron Hafner,
      who serves as a Consultant. Each of the employment and consulting agreements
      provides for a term of three (3) years and contains certain restrictions that
      prevent or limit the contracting party from competing against Celtic. See Notes
      1 and 5 to the financial statements for additional information regarding the
      Celtic asset purchase.





Further,
      at September 30, 2005, the Company had largely completed a $12.8 million public
      stock offering, and had received proceeds, net of underwriting costs, of
      approximately $11.1 million. On November 8, 2005, the Company closed its public
      offering registered on Form SB-2 and issued a total of 827,425 shares ($12.8
      million) of its common stock. 53,613 of these shares ($831 thousand) were issued
      to principals of Celtic on August 31, 2005 as part of the Celtic asset
      acquisition. Please refer to the Company’s Registration Statements on Form S-4
      and SB-2, as amended, for more information regarding the holding company
      reorganization, the Celtic acquisition and the stock offering.





The
      following discussion is designed to provide a better understanding of
      significant trends related to the Company’s financial condition, results of
      operations, liquidity, capital resources and interest rate sensitivity of the
      Company, the Bank, and Celtic (collectively the “Company”). This discussion
      focuses primarily on the results of operations of the Company on a consolidated
      basis for the three and nine months ended September 30, 2006 and 2005, and
      the
      financial condition of the Company as of September 30, 2006 and December 31,
      2005. Comparison of the three and nine months ended September 30, 2006 to
      September 30, 2005 is primarily impacted by the Company’s growth and the
      above-mentioned acquisition and stock offering. For a more complete
      understanding of the Company and its operations, reference should be made to
      the
      financial statements included in this report and to the Bank’s audited financial
      statements for the years ended December 31, 2004 and 2003 and the Company’s Form
      10-KSB for the year ended December 31, 2005, as amended.





Our
      continued growth since commencement of operations in September 2001 has been
      a
      primary factor impacting profitability over the periods reflected in this
      discussion. Profitability for the three and nine months ended September 30,
      2006
      was impacted by the Celtic acquisition as well as loan growth. However, although
      the Company anticipates that continued growth will further enhance the results
      of operations, the Company’s future results of operations could materially
      differ from those suggested by the forward-looking statements contained in
      this
      report or the annualized results of our operations for the three and nine months
      ended September 30, 2006, depending upon changes to things such as: competition
      within the banking industry; changes in the interest rate environment; general
      economic conditions, nationally, regionally and in our market areas, including
      declines in real estate values; the effects of terrorism and the conduct of
      the
      war on terrorism by the United States and its allies; the regulatory
      environment; business conditions and inflation; the securities markets;
      technology; regulatory compliance issues; planned asset growth; unanticipated
      loan losses; unanticipated increases in operating expenses; and the ability
      to
      generate fee and other non-interest income.





This
      Quarterly Report on Form 10-QSB contains certain forward-looking information
      about the Company and its subsidiaries, which statements are intended to be
      covered by the safe harbor for “forward-looking statements” provided by the
      Private Securities Litigation Reform Act of 1995. All statements other than
      statements of historical fact are forward-looking statements. Such statements
      involve inherent risks and uncertainties, many of which are difficult to predict
      and are generally beyond the control of the Company. We caution readers that
      a
      number of important factors could cause actual results to differ materially
      from
      those expressed in, implied or projected by, such forward-looking
      statements.










**Critical
      Accounting Policies**





***Use
      of Estimates.*** The
      Company’s financial statements and the notes thereto, have been prepared in
      accordance with accounting principles generally accepted in the United States
      of
      America. The preparation of our financial statements requires us to make a
      number of estimates and assumptions that affect the reported amounts and
      disclosures in the financial statements. On an ongoing basis, the Company
      evaluates estimates and assumptions based upon historical experience and various
      other factors and circumstances. The Company believes that these estimates
      and
      assumptions are reasonable; however, actual results may differ significantly
      from these estimates and assumptions which could have a material impact on
      the
      carrying value of assets and liabilities at the balance sheet dates and on
      our
      results of operations for the reporting periods.





The
      accounting policies that involve significant estimates and assumptions, which
      have a material impact on the carrying value of certain assets and liabilities,
      are considered critical accounting policies. The Company has identified the
      policies for the allowance for loan and lease losses, securities available
      for
      sale, accounting for goodwill, and income taxes as critical accounting policies.
      These policies are summarized below.





***Allowance
      for Loan and Lease Losses*** .
      The
      Company maintains an allowance for loan and lease losses at an amount, which
      the
      Company believes, is sufficient to provide adequate protection against losses
      in
      the loan portfolio. Our periodic evaluation of the adequacy of the allowance is
      based on such factors as our past loan loss experience, known and inherent
      risks
      in the portfolio, adverse situations that have occurred but are not yet known
      that may affect the borrowers’ ability to repay, the estimated value of
      underlying collateral, results of the Company’s collateral monitoring process,
      and economic conditions. As the Company utilizes information currently available
      to evaluate the allowance for loan and lease losses, the allowance for loan
      and
      lease losses is subjective and may be adjusted in the future depending on
      changes in economic conditions or other factors.





During
      the
      time the Company holds collateral, it is subject to credit risks, including
      risks of borrower defaults, bankruptcies and special hazard losses that are
      not
      covered by standard hazard insurance (such as those occurring from earthquakes
      or floods). Although the Company has established an allowance for loan and
      lease
      losses that the Company considers adequate, there can be no assurance that
      the
      established allowance for loan and lease losses will be sufficient to offset
      losses on loans in the future. Detailed information concerning the Bank’s loan
      loss methodology is contained in this Item 2 below under “—Allowance and
      Provision for Loan and Lease Losses.”





***Securities
      Available-for-Sale*** **.** Securities
      available-for-sale are recorded at fair value, based on quoted market prices.
      Unrealized holding gains and losses, net of income taxes, in securities
      available-for-sale, based on quoted market prices, are reported as other
      comprehensive income (loss) in the period incurred. Premiums and discounts
      on
      purchased securities are recognized as an adjustment to yield over the term
      of
      the security. Declines in the fair value of securities available-for-sale below
      the original purchase price that are deemed to be other than temporary are
      reflected in earnings as realized losses. Gains and losses on the sale of
      securities available-for-sale are recorded on the trade date and are determined
      using the specific identification method.





***Goodwill*** .
      Goodwill
      is not amortized, but is evaluated for possible impairment at least annually
      and
      more frequently if events and circumstances indicate that the asset might be
      impaired. Impairment is the condition that exists when the carrying amount
      of
      the asset exceeds its implied fair value. The goodwill impairment test involves
      comparing the fair value of Celtic’s assets and liabilities with its carrying
      amount, including goodwill.





***Income
      Taxes*** .
      The
      Company records provision for income taxes under the asset liability method.
      Deferred tax assets and liabilities are reflected at currently enacted income
      tax rates applicable to the period in which the deferred tax assets or
      liabilities are expected to be realized or settled. As changes in tax laws
      or
      rates are enacted, deferred tax assets and liabilities are adjusted through
      the
      provision for income taxes. Deferred taxes result from temporary differences
      in
      the recognition of certain income and expense amounts between our financial
      statements and our tax returns. The principal items giving rise to these
      differences include the allowance for loan and lease losses, depreciation,
      and
      organization and start-up costs. We have recognized deferred income tax assets
      as of September 30, 2006 and December 31, 2005, of $438 thousand and $322
      thousand, respectively. The Company evaluates the realizability of deferred
      tax
      assets and liabilities based upon anticipated taxable income from forecast
      models.










**General**





The
      Company earned $446 thousand for the three months ended September 30, 2006,
      or
      $0.23 per diluted share, and $1.4 million or $0.73 per diluted share, for the
      nine months ended September 30, 2006. This compares to earnings of $13 thousand
      or $0.01 per diluted share and $222 thousand or $0.19 per diluted share for
      the
      same periods in 2005. Increase in net interest income from continued loan growth
      and the Celtic acquisition more than offset increases in operating expenses
      in
      the third quarter.





Total
      assets increased $29.6 million or 18%, to $194.3 million at September 30, 2006,
      from $164.7 million at December 31, 2005. Loans, net of unearned income,
      increased 15% to $156.5 million at September 30, 2006, from $136.1 million
      at
      December 31, 2005. The increases in total assets and loans were primarily funded
      by a $21.5 million increase in deposits to $134.1 million at September 30,
      2006,
      from $112.6 million at December 31, 2005.





Stockholders’
      equity was $24.5 million at September 30, 2006, compared to $22.8 million at
      December 31, 2005. The increase reflects continued profitability during the
      period.





The
      following sections present various tables reflecting the Company’s results of
      operations and financial condition for the dates indicated below. The Bank’s
      averages and rates have been calculated using daily averages. Celtic’s
      interest-earning assets and interest-bearing liabilities averages and rates
      have
      been calculated using daily averages. Monthly averages were used for the balance
      of Celtic’s assets and liabilities, for the Company’s separate assets and
      liabilities, and for San Marcos Building, LLC; however, these balances do not
      impact interest-earning assets or interest-bearing liabilities. Further,
      management believes the impact of using monthly versus daily average balances
      for these items is not material. No assurance can be given that the annualized
      rates and results of operations for the three and nine months ended September
      30, 2006 is indicative of the rates and results of operations that may be
      expected for the year ending December 31, 2006.








**RESULTS
      OF OPERATION**





**Net
      Interest Income and Net Interest Margin**





The
      Company’s earnings depend largely upon the difference between the income we
      receive from interest-earning assets, which are principally our loan portfolio
      and investment securities; and the interest paid on our interest-bearing
      liabilities, which consist of deposits and borrowings. This difference is net
      interest income. Net interest margin is net interest income expressed as a
      percentage of average total interest-earning assets.





The
      following table provides information, for the periods indicated, on the average
      amounts outstanding for the major categories of average interest-earning assets
      and interest-bearing liabilities, the amount of interest earned or paid, the
      yields and rates on major categories of interest-earning assets and
      interest-bearing liabilities and the net interest margin.































**Average
                Balances and Rates/Yields**
              **For
                the Three Months Ended September 30,**(dollars
                in thousands)**2006**
            
            **2005****Average**
              **Balance**
            
            **Interest
                Income/**
              **Expense**
            
            **Average
                Rate/**
              **Yield
                (1)**
            
            **Average**
              **Balance**
            
            **Interest**
              **Income/**
              **Expense**
            
            **Average
                Rate/**
              **Yield
                (1)****Assets**Investment
                Securities
            
            $
            3,221
            
            $
            40
            
            
            4.93
            %
            $
            3,594
            
            $
            39
            
            
            4.31
            %Interest-earning
                deposits
            
            
            5,703
            
            
            66
            
            
            4.59
            %
            
            3,241
            
            
            26
            
            
            3.24
            %Federal
                funds sold
            
            
            9,726
            
            
            133
            
            
            5.43
            %
            
            9,952
            
            
            88
            
            
            3.49
            %Loans
                (2)
            
            
            151,928
            
            
            4,152
            
            
            10.84
            %
            
            113,298
            
            
            2,531
            
            
            8.86
            %Total
                Interest-Earning Assets
            
            
            170,578
            
            $
            4,391
            
            
            10.21
            %
            
            130,085
            
            $
            2,684
            
            
            8.19
            %Non
                Interest-earning Assets
            
            
            16,145
            
            
            
            
            
            
            
            
            12,402**Total
                Assets**
            
            $
            186,723
            
            
            
            
            
            
            
            $
            142,487**Liabilities**Transaction
                & NOW
            
            $
            6,328
            
            $
            18
            
            
            1.13
            %
            $
            7,467
            
            $
            19
            
            
            1.01
            %Savings
                & Money Market
            
            
            27,442
            
            
            265
            
            
            3.83
            %
            
            21,375
            
            
            124
            
            
            2.30
            %Time
                deposits
            
            
            77,049
            
            
            943
            
            
            4.86
            %
            
            60,594
            
            
            542
            
            
            3.55
            %Borrowings
            
            
            26,059
            
            
            451
            
            
            6.87
            %
            
            16,273
            
            
            183
            
            
            4.45
            %Total
                Interest-Bearing Liabilities
            
            
            136,878
            
            $
            1,677
            
            
            4.86
            %
            
            105,709
            
            $
            868
            
            
            3.26
            %Demand
                deposits
            
            
            24,429
            
            
            
            
            
            
            
            
            19,945Other
                liabilities
            
            
            1,222
            
            
            
            
            
            
            
            
            933**Total
                Liabilities**
            
            
            162,529
            
            
            
            
            
            
            
            
            126,587Shareholders’
                Equity
            
            
            24,194
            
            
            
            
            
            
            
            
            15,900Total
                Liabilities and Shareholders’ Equity
            
            $
            186,723
            
            
            
            
            
            
            
            $
            142,487Consolidated
                Net Interest Income/Net Interest Margin (3)
            
            
            
            
            $
            2,714
            
            
            6.31
            %
            
            
            
            $
            1,816
            
            
            5.54
            %





1
            The
                ratios for these periods have been annualized using actual days.




2
            Average
                loans are net of unearned loan fees and allowances for loan and lease
                losses. Unearned loan fees were $302 thousand and $347 thousand at
                September 30, 2006 and 2005, respectively. Allowances for loan and
                lease
                losses were $2.06 million and $1.6 million at September 30, 2006
                and 2005,
                respectively. Interest income from loans includes loan fees of $117
                thousand and $46 thousand for the three months ended September 30,
                2006
                and 2005, respectively.





3
            Net
                interest margin is calculated by dividing net interest income by
                average
                interest-earning assets.




***Three
      Months Ended September 30, 2006 and 2005.*** Average
      interest-earning assets increased to $170.6 million during the three months
      ended September 30, 2006, from $130.1 million during the same period in 2005.
      The average yield on these assets increased to 10.21% from 8.19%. Average
      interest-bearing liabilities, consisting primarily of interest-bearing deposits,
      increased to $136.9 million during the three months ended September 30, 2006,
      from $106 million during the same period in 2005. The average rate paid on
      interest-bearing liabilities increased to 4.86% for the three months ended
      September 30, 2006, from 3.26% for the same period in 2005. The increase in
      the
      yield on interest-earning assets was primarily the result of the prime rate
      increases experienced since September 2005 as well as the addition of Celtic
      loans, which earn relatively higher yields. The increase in the rate paid on
      interest-bearing liabilities resulted from increases in deposit rates and an
      increase in prime-rate-based borrowings related to Celtic since September 2005.
      Average noninterest-bearing demand deposit accounts, consisting primarily of
      business checking accounts, increased 22.6% for the three months ended September
      30, 2006 to $24.4 million from $19.9 million for the same period in
      2005.










Net
      interest income for the three months ended September 30, 2006, was $2.7 million,
      which increased $1.8 million or 49.5% over the same period in the prior year.
      Our net interest margin increased 77 basis points to 6.31% for the three months
      ended September 30, 2006, compared to 5.54% for the same period in 2005. The
      net
      interest margin increase resulted primarily from the repricing lag between
      interest bearing deposits and loans in a rising rate market, and the higher
      net
      interest margin from the Celtic loan portfolio.




**Average
                  Balances and Rates/Yields**
                **For
                  the nine Months Ended September 30,**(dollars
                  in thousands)**2006**
              
              **2005****Average**
                **Balance**
              
              **Interest
                  Income/**
                **Expense**
              
              **Average**
                **Rate/**
                **Yield
                  (1)**
              
              **Average**
                **Balance**
              
              **Interest**
                **Income/**
                **Expense**
              
              **Average**
                **Rate/**
                **Yield
                  (1)****Assets**Investment
                  Securities
              
              $
              3,301
              
              $
              124
              
              
              5.02
              %
              $
              3,372
              
              $
              109
              
              
              4.33
              %Interest-earning
                  deposits
              
              
              5,099
              
              
              170
              
              
              4.46
              %
              
              2,995
              
              
              61
              
              
              2.74
              %Federal
                  funds sold
              
              
              8,983
              
              
              336
              
              
              5.00
              %
              
              7,891
              
              
              187
              
              
              3.16
              %Loans
                  (2)
              
              
              144,264
              
              
              11,834
              
              
              10.97
              %
              
              100,222
              
              
              6,019
              
              
              8.03
              %Total
                  Interest-Earning Assets
              
              
              161,647
              
              
              12,464
              
              
              10.31
              %
              
              114,480
              
              
              6,376
              
              
              7.45
              %Non
                  Interest-earning Assets
              
              
              14,681
              
              
              
              
              
              
              
              
              11,246**Total
                  Assets**
              
              $
              176,328
              
              
              
              
              
              
              
              $
              125,726**Liabilities**Transaction
                  & NOW
              
              $
              6,829
              
              
              58
              
              
              1.14
              %
              $
              6,991
              
              
              52
              
              
              1.00
              %Savings
                  & Money Market
              
              
              24,777
              
              
              637
              
              
              3.44
              %
              
              20,768
              
              
              335
              
              
              2.16
              %Time
                  deposits
              
              
              72,990
              
              
              2,518
              
              
              4.61
              %
              
              55,385
              
              
              1,360
              
              
              3.28
              %Borrowings
              
              
              24,095
              
              
              1,279
              
              
              7.10
              %
              
              11,617
              
              
              313
              
              
              3.60
              %Total
                  Interest-Bearing Liabilities
              
              
              128,691
              
              
              4,492
              
              
              4.67
              %
              
              94,761
              
              
              2,060
              
              
              2.91
              %Demand
                  deposits
              
              
              22,840
              
              
              
              
              
              
              
              
              18,042Other
                  liabilities
              
              
              1,183
              
              
              
              
              
              
              
              
              703**Total
                  Liabilities**
              
              
              152,714
              
              
              
              
              
              
              
              
              113,506Shareholders’
                  Equity
              
              
              23,614
              
              
              
              
              
              
              
              
              12,220Total
                  Liabilities and Shareholders’ Equity
              
              $
              176,328
              
              
              
              
              
              
              
              $
              125,726Consolidated
                  Net Interest Income/Net Interest Margin (3)
              
              
              
              
              $
              7,972
              
              
              6.59
              %
              
              
              
              $
              4,316
              
              
              5.04
              %




1
            The
                ratios have been annualized.





2
            Average
                loans are net of unearned loan fees and allowances for loan and lease
                losses. Unearned loan fees were $302 thousand and $347 thousand at
                September 30, 2006 and 2005, respectively. Allowances for loan and
                lease
                losses were $2.06 million and $1.6 million at September 30, 2006
                and 2005,
                respectively. Interest income from loans includes loan fees of $483
                thousand and $184 thousand for the nine months ended September 30,
                2006
                and 2005, respectively.




3
            Net
                interest margin is calculated by dividing net interest income by
                average
                interest-earning assets.





***Nine
        Months Ended September 30, 2006 and 2005*** Average
        interest-earning assets increased $47.2 million or 41% to $161.6 million
        during
        the nine months ended September 30, 2006, from $114.5 million during the
        same
        period in 2005. The average yield on these assets increased to 10.31% from
        7.45%. Average interest-bearing liabilities, consisting primarily of
        interest-bearing deposits, increased to $128.7 million during the nine months
        ended September 30, 2006, from $94.8 million during the same period in 2005.
        The
        average rate paid on interest-bearing liabilities increased to 4.67% for
        the
        nine months ended September 30, 2006, from 2.91% for the same period in 2005.
        The increase in the yield on interest-earning assets was primarily the result
        of
        the addition of Celtic loans in September 2005, which earn relatively higher
        yields, and an increase in interest rates during the prior twelve months.
        The
        increase in the rate paid on interest-bearing liabilities resulted from
        increases in deposit rates and an increase in prime-rate-based borrowings
        related to Celtic since September 2005. Average noninterest-bearing demand
        deposit accounts, consisting primarily of business checking accounts, increased
        27.8% for the nine months ended September 30, 2006 to $23 million from $18
        million for the same period in 2005.





Net
      interest income for the nine months ended September 30, 2006, was $8 million,
      which increased $3.7 million or 84.7% over the same period in the prior year.
      Our net interest margin increased 155 basis points to 6.59% for the nine months
      ended September 30, 2006, compared to 5.04% for the same period in 2005. The
      net
      interest margin increase resulted from the repricing lag between interest
      bearing deposits and loans in a rising rate market and the higher net interest
      margin in the Celtic loan portfolio.




**Net
      Interest Income and Rate/Volume Analysis** .





Net
      interest income is affected by changes in the level and the mix of
      interest-earning assets and interest-bearing liabilities. The changes between
      periods in these assets and liabilities are referred to as volume changes.
      The
      impact on net interest income from changes in average volume is measured by
      multiplying the change in volume between the current period and the prior period
      by the prior period rate.





Net
      interest income is also affected by changes in the yields earned on assets
      and
      rates paid on liabilities. These are referred to as rate changes and the impact
      on net interest income from these changes is measured by multiplying the change
      in rate between the current and prior period by the average volume of the prior
      period. Changes in rate-volume between periods, which are measured by the change
      in rate multiplied by the change in volume, are allocated on a pro rata basis
      between the volume and the rate changes. The following table reflects the rate
      and volume changes for the periods indicated:




**Rate/Volume
      Analysis of Net Interest Income**


**For
      the Three Months Ended September 30, 2006**


**Compared
      to the Three Months Ended September 30, 2005**




**Increase
                (Decrease)**
              **Due
                To Change In**(dollars
                in thousands)**Volume**
            
            **Rate**
            
            **Change****Interest-Earning
                Assets**Investment
                Securities
            
            $
            (4
            )
            $
            5
            
            $
            1Interest-earning
                deposits
            
            
            25
            
            
            15
            
            
            40Federal
                Funds Sold
            
            
            (2
            )
            
            47
            
            
            45Loans
            
            
            980
            
            
            641
            
            
            1,621**Total
                Interest Income**
            
            
            999
            
            
            708
            
            
            1,707**Interest-Bearing
                Liabilities**Transaction
                and Now Accounts
            
            
            (3
            )
            
            2
            
            
            (1
            )MMDA
                and Savings
            
            
            42
            
            
            99
            
            
            141Time
                Deposit
            
            
            170
            
            
            231
            
            
            401Borrowings
            
            
            142
            
            
            126
            
            
            268**Total
                Interest Expense**
            
            
            351
            
            
            458
            
            
            809**Net
                Interest Income**
            
            $
            648
            
            $
            250
            
            $
            898













**Rate/Volume
      Analysis of Net Interest Income**


**For
      the Nine Months Ended September 30, 2006**


**Compared
      to the Nine Months Ended September 30, 2005**




**Increase
                (Decrease)**
              **Due
                To Change In**(dollars
                in thousands)**Volume**
            
            **Rate**
            
            **Change****Interest-Earning
                Assets**Investment
                Securities
            
            $
            (2
            )
            $
            17
            
            $
            15Interest-earning
                deposits
            
            
            57
            
            
            52
            
            
            109Federal
                Funds Sold
            
            
            29
            
            
            120
            
            
            149Loans
            
            
            3,173
            
            
            2,642
            
            
            5,815**Total
                Interest Income**
            
            
            3,257
            
            
            2,831
            
            
            6,088**Interest-Bearing
                Liabilities**Transaction
                and Now Accounts
            
            
            (1
            )
            
            7
            
            
            6MMDA
                and Savings
            
            
            74
            
            
            228
            
            
            302Time
                Deposit
            
            
            509
            
            
            649
            
            
            1,158Borrowings
            
            
            507
            
            
            459
            
            
            966**Total
                Interest Expense**
            
            
            1,089
            
            
            1,343
            
            
            2,432**Net
                Interest Income**
            
            $
            2,168
            
            $
            1,488
            
            $
            3,656




**Non-Interest
      Income**





Non-interest
      income includes customer service fees, gains from the sale of SBA loans, rental
      income, and other loan fees and charges.





The
      tables
      below set forth the components of non-interest income as of the periods
      indicated:





**For
                the Three Months Ended September 30**(dollars
                in thousands)**2006**
            
            **2005****Amount**
            
            **Percent**
              **of
                Total**
            
            **Amount**
            
            **Percent**
              **of
                Total**
            
            **2006/2005**
              **Change**
            
            **Percentage**
              **Change**Customer
                service fees & charges
            
            $
            43
            
            
            19.20
            %
            $
            54
            
            
            35.76
            %
            $
            (11
            )
            
            (20.37)
            %Gain
                on sale of SBA loans
            
            
            46
            
            
            20.54
            %
            
            0
            
            
            0
            %
            
            46
            
            
            NM
            %Rental
                income (loss), net
            
            
            (35
            )
            
            (15.63)
            %
            
            33
            
            
            21.86
            %
            
            (68
            )
            
            (206.06)
            %Other
                loan fees & charges
            
            
            170
            
            
            75.89
            %
            
            64
            
            
            42.38
            %
            
            106
            
            
            165.63
            %Total
            
            $
            224
            
            
            100.00
            %
            $
            151
            
            
            100.00
            %
            $
            73
            
            
            48.34
            %As
                a
                percentage of average earning assets
            
            
            
            
            
            0.53
            %
            
            
            
            
            0.46
            %





***Three
      Months Ended September 30, 2006 and 2005.*** Non-interest
      income increased 48% for the three months ended September 30, 2006 as compared
      to the three months ended September 30, 2005. Non-interest income as a
      percentage of average earning assets increased as a result of other loan fees
      associated with Celtic ($80 thousand generated by Celtic for the three months
      ended September 30, 2006). Gain on sale of SBA loans totaling $46 thousand
      for
      the three months ending September 30, 2006 versus zero for the same
      period in 2005 is a result of SBA loan sales of $809 thousand . Rental
      income for the period was reduced while renovations were completed upon the
      departure of a tenant.











**For
                the Nine Months Ended September 30**(dollars
                in thousands)**2006**
            
            **2005****Amount**
            
            **Percent**
              **of
                Total**
            
            **Amount**
            
            **Percent**
              **of
                Total**
            
            **2006/2005**
              **Change**
            
            **Percentage**
              **Change**Customer
                service fees & charges
            
            $
            122
            
            
            14.45
            %
            $
            94
            
            
            17.12
            %
            $
            28
            
            
            29.79
            %Gain
                on sale of SBA loans
            
            
            213
            
            
            25.24
            %
            
            123
            
            
            22.40
            %
            
            90
            
            
            100
            %Rental
                income
            
            
            117
            
            
            13.86
            %
            
            180
            
            
            32.79
            %
            
            (63)
            
            
            (35)
            %Other
                loan fees & charges
            
            
            392
            
            
            46.45
            %
            
            152
            
            
            27.69
            %
            
            240
            
            
            159.60
            %Total
            
            $
            844
            
            
            100.00
            %
            $
            549
            
            
            100.00
            %
            $
            295
            
            
            54.01
            %As
                a
                percentage of average earning assets
            
            
            
            
            
            0.70
            %
            
            
            
            
            0.64
            %




***Nine
      Months Ended September 30, 2006 and 2005.*** Non-interest
      income increased $295 thousand to $844 thousand for the nine months ended
      September 30, 2006 as compared to the nine months ended September 30, 2005.
      The
      increase in non-interest income was attributable to the acquisition of Celtic
      in
      September 2005 and the benefit of nine months of other loan fees in 2006
      totaling $392 thousand ($235 thousand generated by Celtic). Increased income
      associated with SBA loan sale activity totaling $213 which represented an
      increase of $90 thousand or 73%, over $123 thousand for the same period in
      2005
      is attributed to $4 million in SBA loan sales. Loan sales for the same period
      in
      2005 represented $1.6 million. Rental income for the period was reduced while
      renovations were completed upon the departure of a tenant.







**Non-Interest
      Expense**





Non-interest
      expenses consist of salaries and related benefits, occupancy and equipment
      expense and other expenses.





The
      tables
      below set forth the components of non-interest expenses as of the periods
      indicated:





**For
                the Three Months Ended September 30,**(dollars
                in thousands)**2006**
            
            **2005****Amount**
            
            **Percent**
              **of
                Total**
            
            **Amount**
            
            **Percent**
              **of
                Total**
            
            **2006/2005**
              **Change**
            
            **Percentage**
              **Change**Salaries
                and benefits
            
            $
            1,259
            
            
            61.75
            %
            $
            817
            
            
            51.64
            %
            $
            442
            
            
            54.10
            %Occupancy
                expense
            
            
            130
            
            
            6.38
            %
            
            107
            
            
            6.76
            %
            
            23
            
            
            21.50
            %Furniture
                & Equipment
            
            
            72
            
            
            3.53
            %
            
            80
            
            
            5.06
            %
            
            (8)
            
            
            (10.00)
            %Data
                Processing
            
            
            97
            
            
            4.76
            %
            
            139
            
            
            8.79
            %
            
            (42)
            
            
            (30.22)
            %Advertising
            
            
            63
            
            
            3.09
            %
            
            30
            
            
            1.90
            %
            
            33
            
            
            110.00
            %Professional
                fees
            
            
            190
            
            
            9.32
            %
            
            342
            
            
            21.62
            %
            
            (152)
            
            
            (44.44)
            %Office
                supplies
            
            
            16
            
            
            .78
            %
            
            18
            
            
            1.14
            %
            
            (2)
            
            
            (11.11)
            %Other
                expenses
            
            
            212
            
            
            10.40
            %
            
            49
            
            
            3.10
            %
            
            163
            
            
            332.65
            %Total
            
            $
            2,039
            
            
            100.00
            %
            $
            1,582
            
            
            100.00
            %
            $
            457
            
            
            28.89
            %As
                a
                percentage of average earning assets
            
            
            
            
            
            4.78
            %
            
            
            
            
            4.86
            %




***Three
      Months Ended September 30, 2006 and 2005.*** Our
      non-interest expenses increased by $457 thousand, or 28.9%, to $2 million for
      the three months ended September 30, 2006, compared to the three months ended
      September 30, 2005. Salaries and employee benefits increased $442 thousand,
      or
      54.10% for the three months ended September 30, 2006 related to staffing
      increases to support loan growth and deposit activities and increased
      administrative staff including a controller, director of human resources and
      a
      director of operations. Professional fees decreased $152 thousand, or 44.4%,
      to
      $190 thousand for the three months ended September 30, 2006 as a result of
      the
      Celtic acquisition and the incorporation of the parent company included in
      2005’s activity. Remaining expenses increased in line with business growth and
      the addition of Celtic.













**For
                the Nine Months Ended September 30,**(dollars
                in thousands)**2006**
            
            **2005****Amount**
            
            **Percent
                of Total**
            
            **Amount**
            
            **Percent
                of Total**
            
            **2006/2005**
              **Change**
            
            **Percentage**
              **Change**Salaries
                and benefits
            
            $
            3,671
            
            
            61.27
            %
            $
            1,940
            
            
            50.43
            %
            $
            1731
            
            
            89.23
            %Occupancy
                expense
            
            
            392
            
            
            6.54
            %
            
            240
            
            
            6.24
            %
            
            152
            
            
            63.33
            %Furniture
                & Equipment
            
            
            226
            
            
            3.77
            %
            
            220
            
            
            5.72
            %
            
            6
            
            
            2.73
            %Data
                Processing
            
            
            289
            
            
            4.82
            %
            
            239
            
            
            6.21
            %
            
            50
            
            
            20.92
            %Advertising
            
            
            160
            
            
            2.67
            %
            
            82
            
            
            2.13
            %
            
            78
            
            
            95.12
            %Professional
                fees
            
            
            559
            
            
            9.33
            %
            
            719
            
            
            18.69
            %
            
            (160
            )
            
            (22.25)
            %Office
                supplies
            
            
            59
            
            
            .98
            %
            
            53
            
            
            1.38
            %
            
            6
            
            
            11.32
            %Other
                expenses
            
            
            636
            
            
            10.61
            %
            
            354
            
            
            9.20
            %
            
            281
            
            
            79.38
            %Total
            
            $
            5,992
            
            
            100.00
            %
            $
            3,847
            
            
            100.00
            %
            $
            2,145
            
            
            55.76
            %As
                a
                percentage of average earning assets
            
            
            
            
            
            4.94
            %
            
            
            
            
            4.48
            %




***Nine
      Months Ended September 30, 2006 and 2005.*** Our
      non-interest expenses increased by $2.1 million, or 55.76%, to $6 million for
      the nine months ended September 30, 2006, compared to the nine months ended
      September 30, 2005. Salaries and employee benefits increased to $3.7 million,
      or
      89.23% for the nine months ended September 30, 2006 related to staffing
      increases to support loan growth and deposit activities and increased
      administrative staff including a controller, director of human resources and
      a
      director of operations. Occupancy expense increased $152,000, or 63.33% to
      $392
      thousand for the nine months ended September 30, 2006 as a result of the
      addition of Celtic’s three locations in Santa Monica, Arizona and Washington.
      Remaining expenses increased in line with business growth.








**Provision
      for Loan Losses and Lease Losses**




Credit
        risk is inherent in the business of making loans. The Company sets aside
        an
        allowance for loan and lease losses through periodic charges to earnings,
        which
        are reflected in the income statement as the provision for loan and lease
        losses. These charges are in amounts sufficient to achieve an allowance for
        loan
        and lease losses that, in management's judgment, is adequate to absorb losses
        inherent in the Company's loan portfolio.
  For
        the
        three months ended September 30, 2006 and September 30, 2005, the provision
        for
        loan and lease losses was $113, 000 and $350,000, respectively and $336,000
        and
        $633,000 for the nine months ended September 30, 2006 and September 30, 2005.
        The loan loss provisions were significantly lower in 2006 than in 2005 as
        a
        result of the acquisition of Celtic Capital Corporation and the corresponding
        loan loss provision of $234 thousand. The procedures for monitoring the adequacy
        of the allowance, and detailed information on the allowance, are included
        below
        in "Allowance for Loan and Lease Losses."


**Income
      Taxes**





The
      Company’s effective tax rates were approximately 43.0% for the three and nine
      months ended September 30, 2006 and 42.1% for the nine months ended September
      30, 2005. The increase in the effective tax rate for the three months and nine
      months ended September 30, 2006 as compared to September 30, 2005 reflects
      the
      complete utilization of net operating loss carry forwards and tax impact of
      implementing FAS 123(R), Share-based
      Payment.








**FINANCIAL
      CONDITION**





**Investments**





In
      order
      to maintain a reserve of readily saleable assets to meet our liquidity and
      loan
      requirements, the Company purchases United States Treasury and Agency securities
      and other investments. Sales of Federal Funds and short-term loans to other
      banks are also regularly utilized. Placement of funds in certificates of deposit
      with other financial institutions may be made as alternative investments pending
      utilization of funds for loans or other purposes. None of our securities are
      pledged to meet security requirements imposed as a condition to receipt of
      public fund deposits or for other purposes. Our policy is to stagger the
      maturities of our investments to meet our overall liquidity
      requirements.









At
      September 30, 2006 and December 31, 2005 our investment portfolio consisted
      of
      U.S. Agency securities and mortgage backed securities. All of our securities
      are
      classified as available-for-sale. Available-for-sale securities are bonds,
      notes, debentures, and certain equity securities that are not classified as
      trading securities or as held-to-maturity securities. Although the Company
      currently has the intent and the ability to hold the securities in its
      investment portfolio to maturity, the securities are all marketable and are
      classified as “available for sale” to allow maximum flexibility with regard to
      interest rate risk and liquidity management. Unrealized holding gains and
      losses, net of tax, on available-for-sale securities are reported as a net
      amount in a separate component of capital until realized. Gains and losses
      on
      the sale of available-for-sale securities are determined using the specific
      identification method. Premiums and discounts are recognized in interest income
      using the interest method over the period to maturity.




The
      following table summarizes the amounts and the distributions of our investment
      securities as of the dates indicated:




**Investment
                  Portfolio**(dollars
                  in thousands)**As
                  of September 30, 2006**
              
              **As
                  of December 31, 2005****Amortized**
                **Cost**
              
              **Gross**
                **Unrealized**
                **Gains**
              
              **Gross**
                **Unrealized**
                **Losses**
              
              **Fair**
                **Value**
              
              **Amortized**
                **Cost**
              
              **Gross**
                **Unrealized**
                **Gains**
              
              **Gross**
                **Unrealized**
                **Losses**
              
              **Fair**
                **Value**(dollars
                  in thousands)Available-for-sale
                  securities:U.S.
                  Government Agency Securities
              
              $
              2,250
              
              
              —
              
              $
              (33
              )
              $
              2,217
              
              $
              2,496
              
              
              —
              
              $
              (41
              )
              $
              2,455Mortgage-backed
                  Securities
              
              
              817
              
              
              —
              
              
              (24
              )
              
              793
              
              
              973
              
              
              1
              
              
              (27
              )
              
              947Total
                  securities
              
              $
              3,067
              
              
              —
              
              $
              (57
              )
              $
              3,010
              
              $
              3,469
              
              $
              1
              
              $
              (68
              )
              $
              3,402


As
      of
      September 30, 2006 and December 31, 2005, the Bank also owned $60 thousand
      in
      Pacific Coast Bankers’ Bank common stock. In addition, as of September 30, 2006
      and December 31, 2005, the Bank owned $896 thousand and $588 thousand,
      respectively, in Federal Home Loan Bank stock.





**Loans**





**Loan
      Categories.** The
      following table sets forth the components of total net loans outstanding in
      each
      category for the Company at the dates indicated:




**September
                30, 2006**
            
            **December
                31, 2005****Amount**
            
            **Percent**
              **of
                Total**
            
            **Amount**
            
            **Percent**
              **of
                Total**Real
                Estate Loans
            
            (dollars
                in thousands)Construction
                & Land Development Loans
            
            $
            27,699
            
            
            18
            %
            $
            32,033
            
            
            23
            %Real
                Estate 1st Trust Deed
            
            
            52,771
            
            
            33
            %
            
            41,344
            
            
            30
            %Other
                Real Estate Mortgage
            
            
            6,006
            
            
            4
            %
            
            2,141
            
            
            2
            %Total
                Real Estate
            
            
            86.476
            
            
            55
            %
            
            75,518
            
            
            55
            %Business
                Secured Loans
            
            
            61,316
            
            
            39
            %
            
            52,221
            
            
            38
            %Business
                Unsecured Loans
            
            
            2,404
            
            
            2
            %
            
            1,390
            
            
            1
            %Consumer
                and Other
            
            
            6,600
            
            
            4
            %
            
            7,410
            
            
            6
            %**Total
                Loans**
            
            
            156,796
            
            
            100
            %
            
            136,539
            
            
            100
            %Less
                deferred Loan Income
            
            
            (301
            )
            
            
            
            
            (429
            )Less
                Allowance for Loan and Lease Losses
            
            
            (2,058
            )
            
            
            
            
            (1,784
            )**Net
                Loans**
            
            $
            154,437
            
            
            
            
            $
            134,326











The
      Company provides a variety of credit products to meet the needs of borrowers
      in
      our service area. The Company offers both secured and unsecured loans for
      working capital, equipment acquisition, expansion, purchase or improvement
      of
      real property, as well as seasonal loans and lines of credit. The Company
      maintains a portfolio of interim construction loans. Other real estate loans
      consist primarily of commercial loans secured by real estate collateral and
      “mini-perm” real estate financing. Commercial loans are made available to
      business and professional customers. Consumer loans are offered for a variety
      of
      personal, family household needs, including automobiles, home equity loans
      and
      unsecured revolving lines of credit.





The
      Company’s loan portfolio has consistently increased since the Bank commenced
      operations in September 2001. Furthermore, the Company also had the positive
      addition of Celtic’s $16 million in business secured loans effective September
      1, 2005. The Bank’s loan growth is the result of increased lending in our
      immediate market area and the opening of an additional banking office in Poway
      in 2004, which services the nearby communities of Poway, Carmel Mountain, Rancho
      Bernardo, Rancho Penesquitos, Ramona and Scripps Ranch. In addition, our
      increasing lending limits that result from the growth of our capital allows
      us
      to make larger loans. The size of a loan that a bank can make is limited by
      regulation to a percentage of the institution’s regulatory capital.




***Loan
      Origination and Underwriting.*** Our
      primary lending emphasis is in construction, commercial real estate and business
      loans, including SBA loans. Major credit risk factors for all categories of
      loans include: changes in national and local economic conditions; the
      experience, ability and depth of our lending staff; changes in the quality
      of
      our internal and external loan review systems; and the impact of certain
      external factors such as competition, legal and regulatory changes. For
      construction and other real estate related loans, additional major risk factors
      include: changes in the valuation of real property; increases in commercial,
      industrial and retail vacancy rates; market absorption levels; excess market
      supply; and rising interest rates. To address these credit risks, all loan
      requests require preparation of a credit memorandum that details the purpose
      of
      the loan, terms, repayment source, collateral, and credit rating of the borrower
      and a general description of the borrower’s background and/or business. The loan
      request is then subjected to various levels of review to assure that larger
      loans are reviewed by more experienced lenders and/or the Bank’s loan committee.
      The Bank’s loan policy establishes criteria for various types of loans, such as
      loan to collateral value ratios or loan to debt ratios. Further, the Bank
      utilizes outside loan reviewers to review and assess the loans made on an
      ongoing basis.





Celtic
      originates business loans that are collateralized primarily by business
      property. The principal factors considered in making lending decisions are
      the
      amount of the loan in comparison to the value of the collateral, the borrower’s
      financial condition and the borrower’s capacity to repay the loan. Celtic
      attempts to minimize lending risk by limiting the total amount loaned to any
      one
      borrower. Additionally, Celtic monitors and restricts its credit exposure in
      specific industries and geographic areas.





Current
      appraisals or evaluations, insurance and perfected liens are generally required
      for any collateral taken on loans.





***Loan
      Commitments.*** In
      the
      normal course of business, the Company maintains outstanding loan commitments
      to
      extend credit. The Company uses the same credit policies in making loan
      commitments as the Company does in extending loans to customers. The Company
      evaluates each customer’s creditworthiness on a case-by-case basis. The amount
      of collateral obtained, if deemed necessary, is based on management’s credit
      evaluation of the customer. The types of collateral held varies, but may include
      accounts receivable, inventory, property, equipment and residential and income
      producing commercial properties. The Company had unfunded loan commitments,
      including standby letters of credit, totaling $47.1 million and $39.2 million
      at
      September 30, 2006 and December 31, 2005, respectively, primarily consisting
      of
      commercial, construction and equity lines of credit. Based upon the Company’s
      experience, the outstanding loan commitments and standby letters of credit
      are
      expected to grow throughout the year as loan demand continues to increase,
      subject to, economic conditions.






**Non-Performing
      Assets*.***




It
      is our
      policy to place loans on non-accrual status when principal or interest payments
      are past due 90 days or more. Certain loans will be placed on non-accrual
      earlier if there is a reasonable doubt as to the collectibility of principal
      and
      interest. Loans, which are in the process of renewal in the normal course of
      business or are well secured and in the process of collection will continue
      to
      accrue interest if the Company considers the risk of loss to be
      minimal.




Non-performing
      assets at September 30, 2006 increased $835 thousand to $1.6 million, from
      $726
      thousand at December 31, 2005, and represented 1.00% and 0.53% of total gross
      loans, respectively. Nonperforming assets consists of one construction and
      land
      development loan, one real estate 1 st trust
      deed loan and one business secured loan. During the quarter, a charge off of
      $62
      thousand was recorded related to the prior quarter’s one non-accrual loan. This
      loan was restructured; however it will remain on non-accrual until adequate
      payment history on the loan has been established. The collateral supporting
      the
      new non-accrual loans is presently being marketed by the borrowers. There were
      no other non-accrual loans, loans past due 90 days or more, restructured loans,
      or impaired loans or loans that have or had a higher than normal risk of
      loss.









The
      following table summarizes the components of the company’s non-performing assets
      as of the dates indicated:


**September
                30,**
            
            
            **December
                31,**
            
            
            **September
                30,****2006**
            
            
            **2005**
            
            
            **2005****Amount**
            
            
            **Amount**
            
            
            **Amount****(dollars
                in thousands)****Non
                Accrual Loan Category:**Real
                Estate Loans:
            
            $
            0
            
            $
            0
            
            $
            0Construction
                & Land Development Loans:
            
            
            659
            
            
            726
            
            
            726Real
                Estate 1st Trust Deed:
            
            
            402
            
            
            -
            
            
            -Other
                Real Estate Mortgage:
            
            
            -
            
            
            -
            
            
            -Business
                Secured Loans
            
            
            500
            
            
            -
            
            
            -Business
                Unsecured Loans
            
            
            -
            
            
            -Consumer
                and Other:
            
            
            -
            
            
            -
            
            
            -**Total
                Non Accrual Loan Category**
            
            
            1,561
            
            
            726
            
            
            726**Loan
                still Accruing Past 90 days or more as to principal or Interest**Real
                Estate Loans:
            
            
            -
            
            
            -
            
            
            -Construction
                & Land Development Loans:
            
            
            -
            
            
            -
            
            
            -Real
                Estate 1st Trust Deed:
            
            
            -
            
            
            -
            
            
            -Other
                Real Estate Mortgage:
            
            
            -
            
            
            -
            
            
            -Business
                Secured Loans
            
            
            -
            
            
            -
            
            
            -Business
                Unsecured Loans
            
            
            -
            
            
            -
            
            
            -Consumer
                and Other:
            
            
            -
            
            
            -
            
            
            -**Total
                Loan still Accruing Past 90 days or more as to principal or Interest**
            
            
            0.00
            
            
            0.00
            
            
            0.00Restructured
                and Renegotiated LoanTotal
                Non Performing Loan Category
            
            
            1,561
            
            
            726
            
            
            726Other
                real estate Owned**Total
                nonperforming assets**
            
            $
            1,561
            
            $
            726
            
            $
            726**Non-performing
                Loan Category as a percentage of Total loans**
            
            
            1.00
            %
            
            0.53
            %
            
            0.57
            %**Non-performing
                Assets as a percentage of Total loans and other real estate owned**
            
            
            1.00
            %
            
            0.53
            %
            
            0.57
            %Allowance
                to non-performing loans
            
            
            131.86
            %
            
            245.73
            %
            
            224.66
            %Allowance for
                Loan & Lease Losses
            
            $
            2,058
            
            $
            1,784
            
            $
            1,631








As
      of
      September 30, 2006, the Company has identified $2.5 million in loans on our
      internal watch list for special attention by our management and board of
      directors, of which $229 thousand is guaranteed by government and other
      agencies. These loans reflect weakened financial conditions or evidence other
      factors warranting closer monitoring, but are performing in accordance with
      their terms.









**Allowance
      and Provision for Loan and Lease Losses**





The
      Company maintains an allowance for loan and lease losses to provide for probable
      losses in the loan portfolio. Additions to the allowance are made by charges
      to
      operating expenses in the form of a provision for loan and lease losses. All
      loans, which are judged to be uncollectible, are charged against the allowance
      while any recoveries are credited to the allowance. The Company has instituted
      loan policies, designed primarily for internal use, to adequately evaluate
      and
      assess the analysis of risk factors associated with our loan portfolio and
      to
      enable us to assess such risk factors prior to granting new loans and to assess
      the sufficiency of the allowance. The Company conducts a critical evaluation
      of
      the loan portfolio monthly. This evaluation includes an assessment of the
      following factors: the results of our internal loan review and our collateral
      monitoring process, any external loan review and any regulatory examination,
      loan loss experience, estimated potential loss exposure on each credit,
      concentrations of credit, value of collateral, and any known impairment in
      the
      borrower’s ability to repay and present economic conditions. Until the Company
      has established some historical trend of losses, it relies on industry standards
      to compare allowance adequacy.




Each
      month
      the Company also reviews the allowance and makes additional transfers to the
      allowance as needed. For the three months ended September 30, 2006 and September
      30, 2005, the provision for loan and lease losses was $113 thousand and $350
      thousand, respectively and $336 thousand and $633 thousand for the nine months
      ended September 30, 2006 and September 30, 2005.





At
      September 30, 2006, the allowance was 1.32% of the loans then outstanding.
      At
      December 31, 2005, the allowance for loan and lease losses was 1.31% of loans
      outstanding. Although the Company deemed these levels adequate, no assurance
      can
      be given that further economic difficulties or other circumstances which would
      adversely affect our borrowers and their ability to repay outstanding loans
      will
      not occur which would be reflected in increased losses in our loan portfolio,
      which losses could possibly exceed the amount then reserved for loan and lease
      losses. Adverse economic conditions, a decline in real estate values, or a
      significant increase in interest rates could negatively affect the construction
      loan business and require an increase in the provision for loan and lease
      losses, which in turn, could adversely affect our future prospects, results
      of
      operations, and profitability.





The
      following table summarizes our loan loss experience, transactions in the
      allowance for loan and lease losses and certain pertinent ratios for the periods
      indicated:




**Nine
                  Months**
                **Ended**
                **September
                  30,**
                **2006**
              
              **Year**
                **Ended**
                **December
                  31,**
                **2005**
              
              **Nine
                  Months**
                **Ended**
                **September
                  30,**
                **2005**(dollars
                  in thousands)**Outstanding
                  loans:**End
                  of the period (1)
              
              $
              156,496
              
              $
              136,110
              
              $
              128,665Average
                  for the period
              
              
              144,264
              
              
              107,448
              
              
              100,22**Allowance
                  for loan and lease losses:**Balance
                  at beginning of period
              
              
              1,784
              
              
              998
              
              
              998Loans
                  charged off
              
              
              (62
              )
              
              —
              
              
              —Recoveries
              
              
              —
              
              
              —
              
              
              —Provisions
                  charged to operating expense
              
              
              336
              
              
              786
              
              
              633Balance
                  at end of period
              
              $
              2,058
              
              $
              1,784
              
              $
              1,631**Ratios:**Net
                  charge-offs (recoveries) to average loans
              
              
              —
              
              
              —
              
              
              —Allowance
                  to loans at period end
              
              
              1.31
              %
              
              1.31
              %
              
              1.27
              %Allowance
                  to non-performing loans
              
              
              132
              %
              
              246
              %
              
              225
              %





(1)
                Loans
                    are gross, which excludes the allowance for loan and lease losses.
                    Non-accrual loans are included in the table for computation purposes,
                    but
                    the foregone interest of such loans is
                    excluded.









**Cash
      and Cash Equivalents** **.**





Cash
      and
      cash equivalents consist of cash on hand and due from correspondent banks,
      Federal funds sold, and balances maintained by Celtic in a non-affiliated bank.
      The Bank maintains balances at correspondent banks adequate to cover daily
      clearings and other charges. Funds in excess of these needs are invested in
      overnight federal funds at correspondent banks. Cash and cash equivalents were
      $21.3 million at September 30, 2006 and $14.9 million at December 31, 2005.
      The
      increase from December 31, 2005 to September 30, 2006 was to provide additional
      liquidity in line with our asset growth.





**Deposits** **.**





Deposits
      represent our primary source of funds to support our various lending and
      investment activities. The majority of our deposits are from individuals and
      businesses within our service area. The Bank has utilized institutional
      deposits. The Bank has also utilized brokered deposits from time to time, but
      they have never exceeded 25% of total deposits. The Bank has no known foreign
      deposits. Celtic does not accept deposits.








The
      following table sets forth the maturity of time certificates of deposit of
      $100,000 or more at September 30, 2006:





**September
                30, 2006**
              **(unaudited)**(dollars
                in thousands)Three
                months or less
            
            $
            7,171Over
                three to six months
            
            
            14,878Over
                six to twelve months
            
            
            12,249Over
                twelve months
            
            
            108Total
            
            $
            34,406








**Borrowings** .





Federal
      Home Loan Bank Advances at September 30, 2006 totaled $19.1 million with a
      month
      end rate of 5.47%. Average borrowings for the three months ended September
      30,
      2006 was $10.7 million with a weighted average rate of 5.37%. Federal Home
      Bank
      Loan Advances at December 31, 2005 totaled $12 million with a rate of 4.39%.
      Average FHLB borrowings for the year ended December 31, 2005 was $10.0 million
      with a weighted average rate of 3.36%. All advances are open-end overnight
      borrowings to supplement liquidity and are repaid during the periods when
      liquidity needs are met with deposits.





Celtic
      has
      a $25 million revolving line-of-credit with a non-affiliated bank. The
      line-of-credit matures in August 2008. The agreement provides for the bank
      to
      advance funds up to the maximum line of credit, provided the total amount of
      outstanding advances at any one time does not exceed the “Borrowers’ Borrowing
      Base” (BBB). The BBB is based on a percentage of the Celtic’s good quality
      accounts receivable, equipment and inventory, pledged to it by its debtors.
      The
      line of credit is subject to covenants requiring Celtic to meet certain leverage
      and net worth ratios and contains restrictions as to the incurrence of
      additional debt, capital expenditures and payment of dividends. Celtic was
      in
      compliance with all covenants as of September 30, 2006. Principal is payable
      on
      demand, and interest is payable monthly at prime minus 0.25%. The outstanding
      balance under this revolving line of credit was $15.5 million at September
      30,
      2006. The underlying loans serve as collateral for the borrowings.





**Capital
      Resources**





Under
      bank
      regulatory capital adequacy guidelines, capital adequacy is measured as a
      percentage of risk-adjusted assets in which risk percentages are applied to
      assets on as well as off-balance sheet, such as unused loan commitments and
      standby letters of credit. The guidelines require that a portion of total
      capital be core, or Tier 1, capital consisting of common shareholders’ equity
      and perpetual preferred stock, less goodwill and certain other deductions.
      Tier
      2 capital consists of other elements, primarily non-perpetual preferred stock,
      subordinated debt and mandatory convertible debt, plus the allowance for loan
      and lease losses, subject to certain limitations. The guidelines also evaluate
      the leverage ratio, which is Tier I capital divided by average
      assets.















The
      following table provides information regarding the Company’s and the Bank’s
      regulatory capital ratios at September 30, 2006 and December 31, 2005. The
      decrease in the Bank’s ratios reflects increased asset growth. At September 30,
      2006 and December 31, 2005, the Company and the Bank met or exceeded regulatory
      capital requirements to be considered “well capitalized,” as defined in the
      regulations issued by the FRB and the FDIC, and it is the Company’s and the
      Bank’s intention to remain “well capitalized” in the future.





**Risk-based
      capital ratios**





**Discovery
                Bancorp:**
            
            **At
                9/30/2006**
            
            **At
                12/31/2005**
            
            **"Well**
              **Capitalized"**
              **Requirement**
            
            **Minimum**
              **Capital**
              **Requirement**Total
                Risk-Based capital ratio
            
            
            14.02
            %
            
            14.73
            %
            
            10.00
            %
            
            8.00
            %Tier
                1 Risk-Based capital ratio
            
            
            12.87
            %
            
            13.57
            %
            
            6.00
            %
            
            4.00
            %Tier
                1 Leverage Ratio
            
            
            12.33
            %
            
            13.45
            %
            
            5.00
            %
            
            4.00
            %**Discovery
                Bank:**Total
                Risk-Based capital ratio
            
            
            10.76
            %
            
            11.33
            %
            
            10.00
            %
            
            8.00
            %Tier
                1 Risk-Based capital ratio
            
            
            9.62
            %
            
            10.17
            %
            
            6.00
            %
            
            4.00
            %Tier
                1 Leverage Ratio
            
            
            9.08
            %
            
            9.92
            %
            
            5.00
            %
            
            4.00
            %




**Liquidity
      and Liquidity Management**





Liquidity
      management for banks requires that funds always be available to pay deposit
      withdrawals and maturing financial obligations in accordance with their terms
      and to meet customer requests for loans. The acquisition of deposits has been
      our primary source of funds used to invest in earning assets. The Bank expects
      that deposits will continue to be the primary source of funds in future periods.
      The Bank emphasizes seeking demand deposits from business customers in our
      market area. When necessary, the Bank also pursues higher cost time deposits,
      including “brokered deposits” (defined to include not only deposits received
      through deposit brokers, but also deposits bearing interest in excess of 75
      basis points over market rates), typically attracting large certificates of
      deposit at high interest rates. Other sources of funds have been the cash
      provided from operations, the proceeds of common stock sales and from
      borrowings.





At
      September 30, 2006 and December 31, 2005, the Bank had “brokered deposits” of
      $21.4 million and $25 million, respectively. We utilized “brokered deposits” and
      deposits from other financial institutions to fund our loan growth.





To
      meet
      liquidity needs, the Bank maintains a portion of our funds in cash deposits
      in
      other banks, Federal Funds sold, and investment securities. As of September
      30,
      2006 and December 31, 2005, our liquidity ratio was 18.07% and 14.66%,
      respectively (defined as liquid assets as a percentage of the total of deposits
      and short term borrowings). Liquid assets were composed of Federal Funds sold,
      available-for-sale investment securities less securities that are pledged to
      secure treasury, tax and loan deposits and other purposes as required by law,
      interest-bearing deposits in other financial institutions and cash and due
      from
      banks. The Bank’s liquidity ratio at September 30, 2006 was above our policy
      target of 15% and at December 31, 2005 was slightly below our policy target
      of
      15%. The Bank monitors our liquidity ratios daily. The Bank attempts to maximize
      its loan to deposit ratios and minimize its liquidity ratio, consistent with
      its
      liquidity needs and policy, to maximize net interest margins.





The
      Bank
      maintains a $2.5 million line of credit with a correspondent bank for the
      purchase of overnight Federal funds. The Bank also has a credit line with the
      Federal Home Loan Bank of San Francisco, which would allow us to borrow up
      to
      15% of our assets. As of September 30, 2006, loans and securities pledged as
      collateral for this facility would have allowed us to borrow up to approximately
      $29.0 million. These facilities have been used regularly to provide funding
      for
      loans at a lower cost than brokered deposits. (See “Borrowings”
above.)





The
      primary sources of liquidity for the Company, on a stand-alone basis, include
      the receipt of dividends from the subsidiaries, borrowings, and our ability
      to
      raise capital. The ability of the Company to obtain funds for payment of
      dividends is dependent upon the subsidiaries’ earnings. The availability of
      dividends from the subsidiaries is also limited by various state and federal
      statues and regulations. Additionally, the Celtic borrowing agreement (see
      “Borrowings” above) requires Celtic to maintain certain financial covenants,
      which may restrict the availability of dividends from Celtic. The Company has
      recently completed a public offering and raised $11.2 million. A part of the
      proceeds was used to repay $550 thousand of the Company’s borrowings and fund
      the $5.2 million cash portion of the Celtic acquisition. The Company intends
      to
      use the remainder of the proceeds to provide resources to enhance the Company’s
      capital, and provide separate working capital for the Company.





**Off-Balance
      Sheet Arrangements**





Information
      concerning our off-balance sheet arrangements can be found in Note 6 to our
      financial statements included in Item 1 of this Report.










**Quantitative
      and Qualitative Disclosures about Market Risk**





Our
      market
      risk arises primarily from credit risk and interest rate risk inherent in our
      lending and deposit taking activities and the risk of inflation. Risk management
      is an important part of our operations and a key element of our overall
      financial results. The FDIC, in recent years, has emphasized appropriate risk
      management, prompting banks to have adequate systems to identify, monitor and
      manage risks. The Bank’s board of directors and committees meet on a regular
      basis to oversee the Bank’s operations. We monitor our business activities and
      apply various strategies to manage the risks to which we are exposed. We have
      adopted various policies and have empowered the committees of its board of
      directors with oversight responsibility concerning different aspects of
      operations. The Bank’s Audit Committee is responsible for overseeing internal
      auditing functions and for interfacing with the independent outside auditors.
      The Loan Committee establishes the Loan Policy, reviews loans made by management
      and approves loans in excess of management’s lending authority. The Loan
      Committee also reviews “watch list” loans and the adequacy of the Bank’s
      allowance for loan and lease losses. The Asset/Liability Risk Committee
      establishes the Investment Policy and the Asset/Liability Policy, reviews
      investments made by management, and monitors the investment portfolio, interest
      rate risk and liquidity planning.





Celtic’s
      Loan Committee also establishes its Loan Policy, reviews loans made by
      management and approves loans in excess of management’s lending authority.
      Celtic’s Loan Committee also reviews “watch list” loans and the adequacy of its
      allowance for loan and lease losses.





***Credit
      Risk*** *.* Credit
      risk generally arises as a result of our lending activities and may be present
      with our investment activities. To manage the credit risk inherent in our
      lending activities, we rely on adherence to underwriting standards and loan
      policies as well as our allowance for loan and lease losses. We employ frequent
      monitoring procedures and take prompt corrective action when
      necessary.





***Interest
      Rate Risk.*** Interest
      rate risk is the exposure of an institution’s financial condition, both earnings
      and the market value of assets and liabilities, to adverse movements in interest
      rates. Interest rate risk results from differences in the maturity or timing
      of
      interest-earning assets and interest-bearing liabilities, changes in the slope
      of the yield curve over time, imperfect correlation in the adjustment of rates
      earned and paid on different instruments with otherwise similar characteristics
      (e.g. three-month Treasury bill versus three-month LIBOR) and from
      interest-rate-related options embedded in financial products (e.g. loan
      prepayments, floors and caps, callable investment securities, early withdrawal
      of time deposits, etc).





The
      potential impact of interest rate risk is significant because of the liquidity
      and capital adequacy consequences that reduced earnings or losses could imply.
      The Bank recognizes and accepts that interest rate risks are a routine part
      of
      its operations and will from time to time impact profits and capital position.
      The objective of interest rate risk management is to control exposure of net
      interest income to risks associated with interest rate movements in the market,
      to achieve consistent growth in net interest income, and to profit from
      favorable market opportunities.




The
      careful planning of asset and liability maturities and the matching of interest
      rates to correspond with this maturity matching is an integral part of the
      active management of an institution’s net yield. To the extent maturities of
      interest-earning assets and interest-bearing liabilities do not match in a
      changing interest rate environment (an interest rate sensitivity “gap”), net
      yields may be affected. Thus, if rate sensitive assets exceed rate sensitive
      liabilities for a given period, the interest rate would be “positively gapped”
and we would benefit from an increase in interest rates. Conversely, if rate
      sensitive liabilities exceed rate sensitive assets for a given period, the
      interest rate would be “negatively gapped” and our earnings would be negatively
      impacted by an increase in interest rates. The Bank is “positively gapped” as of
      September 30, 2006. Even with perfectly matched repricing of interest-earning
      assets and interest-bearing liabilities, risks remain in the form of prepayment
      of assets, timing lags in adjusting certain assets and liabilities that have
      varying sensitivities to market interest rates and basis risk. In our overall
      attempt to match interest-earning assets and interest-bearing liabilities,
      we
      take into account rates and maturities to be offered in connection with our
      certificates of deposit and our variable rate loans.





The
      Bank’s
      policy quantifies acceptable gap ratios. These targets are monitored quarterly
      and reviewed annually by the board of directors to determine acceptable gap
      risks. We monitor and evaluate our gap position, but do not anticipate
      substantial changes in those gap ratios. Celtic loans and borrowings are prime
      based and will be repriced simultaneously when there is a change in the prime
      rate. Therefore its interest rate risk is minimal.





We
      do not
      engage in any hedging activities and do not have any derivative securities
      in
      our portfolio.





The
      Bank
      utilizes the results of a dynamic simulation model to quantify the estimated
      exposure of net interest income to sustained interest rate changes. The
      simulation model, a third-party service, estimates the impact of changing
      interest rates on the interest income from all interest-earning assets and
      the
      interest expense paid on all interest-bearing liabilities reflected on our
      balance sheet. A parallel and pro rata shift in rates over a 12-month period
      is
      assumed. This model is reviewed annually and audited on a regular basis to
      determine accuracy of data and forecasts. The following reflects our net
      interest income sensitivity analysis as of September 30, 2006, based on the
      simulation. This table shows the impact of hypothetical interest rate changes
      on
      net interest income.
















(dollars
                in thousands)**Interest
                Rate Scenario**
            
            
            **Adjusted
                Net**
              **Interest
                Income**
            
            
            **Change**
              **From
                Base**Up
                300 basis points
            
            $
            10,380
            
            
            19.92
            %Up
                200 basis points
            
            $
            9,824
            
            
            12.75
            %Up
                100 basis points
            
            $
            9,271
            
            
            6.40
            %Base
            
            $
            8,713
            
            
            —Down
                100 basis points
            
            $
            8,451
            
            
            (3.01
            )%Down
                200 basis points
            
            $
            8,180
            
            
            (6.12
            )%Down
                300 basis points
            
            $
            7,894
            
            
            (9.40
            )%





The
      above
      analysis shows that the Bank is “positively gapped”, which means that net
      interest income would increase in a rising interest rate environment, and could
      decrease in a declining interest rate environment. However, these results
      illustrate the effect of immediate rate changes, which are unlikely, and do
      not
      consider the effect of loan prepayments or the yield from reinvesting in
      short-term versus long-term instruments.

























**ITEM
      3. CONTROLS AND PROCEDURES**





The
      Company's Chief Executive Officer and its Chief Financial Officer, after
      evaluating the effectiveness of the Company's disclosure controls and procedures
      (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of
      the
      period covered by this report (the "Evaluation Date") have concluded that as
      of
      the Evaluation Date, the Company's disclosure controls and procedures were
      adequate and effective to ensure that material information relating to the
      Company and its consolidated subsidiaries would be made known to them by others
      within those entities, particularly during the period in which this quarterly
      report was being prepared.





Disclosure
      controls and procedures are designed to ensure that information required to
      be
      disclosed by us in the reports that we file or submit under the Exchange Act
      is
      recorded, processed, summarized and reported, within the time periods specified
      in the Securities and Exchange Commission's rules and forms. Disclosure controls
      and procedures include, without limitation, controls and procedures designed
      to
      ensure that information required to be disclosed by us in the reports that
      we
      file under the Exchange Act is accumulated and communicated to our management,
      including our Chief Executive Officer and Chief Financial Officer, as
      appropriate to allow timely decisions regarding required
      disclosure.





There
      were
      no significant changes in the Company’s internal controls or in other factors in
      the third quarter of 2006 that have materially affected, or are reasonably
      likely to materially affect, the Company’s internal controls over financial
      reporting.




**PART
      II — OTHER INFORMATION**





**ITEM
      1. LEGAL PROCEEDINGS**





There
      are
      no material legal proceedings to which the Company is a party or to which any
      of
      its property is subject.





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





Not
      applicable





**ITEM
      3. DEFAULTS UPON SENIOR
      SECURITIES**





Not
      applicable





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





Not
      applicable




**ITEM
      5. OTHER INFORMATION**





Not
      applicable





**ITEM
      6. EXHIBITS**







**Exhibit
                No.**
            **Description
                of Exhibit**31.1
            Certification
                of Chief Executive Officer (Section 302 Certification)31.2
            Certification
                of Chief Financial Officer (Section 302 Certification)32.1
            Certification
                of Periodic Financial Report (Section 906
                Certification)












**SIGNATURES**





In
      accordance with the requirements of the Exchange Act, the registrant caused
      this
      report to be signed on its behalf by the undersigned, thereunto duly
      authorized.








**Discovery
                Bancorp**Dated:
                November 14, 2006
            By:
                /s/ James P. Kelley, IIJames
                P. Kelley, II,President
                and Chief Executive OfficerBy:/s/
                Martin McNabbMartin
                McNabb,Executive
                Vice President and ChiefFinancial
                Officer