Table of Contents

** **

 

** **

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

** **

**Washington, D.C. 20549**

 

**FORM 10-K**

 

**ANNUALREPORT PURSUANT TO SECTION 13 OR 15(D)OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the fiscal year ended December 31, 2008**

**Commission File Number 0-51678**

 

**COMMUNITYVALLEY BANCORP**

(Exact name of registrant as specified in its charter)

 

| **California**                               | ** ** | **68-0479553**                        |
|----------------------------------------------|------------|---------------------------------------|
| State of incorporation                       |       | I.R.S. Employer Identification Number |
|                                         |       |                                  |
| **1360 E. Lassen Avenue  Chico, California** | ** ** | **95973**                             |
| Address of principal executive offices       |       | Zip Code                              |

 

**(530) 899-2344**

Registrant’s telephone number, including area code

 

Securitiesregistered pursuant to Section 12(b) of the Act: **Common Stock, No Par Value**

 

Securitiesregistered pursuant to Section 12(g) of the Act: **None**

 

----

 

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act. Yes  o    No  x

 

Indicateby check mark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Exchange Act.

 

Yes  o    No  x

 

Indicateby check mark whether the Registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

 

Yes  x    No  o

 

Checkif disclosure of delinquent filers pursuant to Item 405 of Regulation S-K isnot contained herein, and will not be contained, to the best of Registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this form10-K. o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reporting company. Seedefinitions of “large accelerated filer,” “accelerated filer,” and “smallerreporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 
| Large  accelerated filer  o |   | Accelerated  filer  o |   | Non-accelerated  filer  o |   | Smaller  Reporting Company  x |
|---------------------------------------|--------|---------------------------------|--------|-------------------------------------|--------|-----------------------------------------|

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes  o    No  x

 

Asof June 30, 2008, the aggregate market value of the voting stock held bynon-affiliates of the Registrant was approximately $30.8 million, based on thesales price reported to the Registrant on that date of $6.75 per share.

 

Sharesof Common Stock held by each officer and director and each person owning morethan five percent of the outstanding Common Stock have been excluded in thatsuch persons may be deemed to be affiliates. This determination of theaffiliate status is not necessarily a conclusive determination for otherpurposes.

 

Thenumber of shares of Common Stock of the registrant outstanding as of March 25,2009 was 6,699,603**.**

 

**DOCUMENTS INCORPORATED BY REFERENCE**

Portionsof the Proxy Statement relating to the Annual Meeting of Shareholders to beheld on June 4, 2009, are incorporated by reference into Part III ofthis Report.

 

 

 

----

Tableof Contents

 

**TABLE OFCONTENTS**

 
| PART I   |   |                                                                                                                     |   | 3      |
|---------------|--------|--------------------------------------------------------------------------------------------------------------------------|--------|--------|
|          |   |                                                                                                                     |   |   |
|          |   | Item 1.  Business                                                                                                        |   | 3      |
|          |   |                                                                                                                     |   |   |
|          |   | Item 1a. Risk Factors                                                                                                    |   | 21     |
|          |   |                                                                                                                     |   |   |
|          |   | Item 1b. Unresolved Staff Comments                                                                                       |   | 24     |
|          |   |                                                                                                                     |   |   |
|          |   | Item 2. Properties                                                                                                       |   | 24     |
|          |   |                                                                                                                     |   |   |
|          |   | Item 3. Legal Proceedings                                                                                                |   | 26     |
|          |   |                                                                                                                     |   |   |
|          |   | Item 4. Submission of Matters to a Vote of  Security Holders                                                             |   | 26     |
|          |   |                                                                                                                     |   |   |
| PART II  |   |                                                                                                                     |   | 26     |
|          |   |                                                                                                                     |   |   |
|          |   | Item 5. Market for Registrants Common  Equity and Related Shareholder Matters and Issuer Purchases of Equity  Securities |   | 26     |
|          |   |                                                                                                                     |   |   |
|          |   | Item 6. Selected Financial Data                                                                                          |   | 28     |
|          |   |                                                                                                                     |   |   |
|          |   | Item 7. Management’s Discussion and  Analysis of Financial Condition and Results of Operations                      |   | 30     |
|          |   |                                                                                                                     |   |   |
|          |   | Item 7a. Quantitative and Qualitative  Disclosures About Market Risk                                                     |   | 54     |
|          |   |                                                                                                                     |   |   |
|          |   | Item 8. Financial Statements and  Supplementary Data                                                                     |   | 54     |
|          |   |                                                                                                                     |   |   |
|          |   | Item 9. Changes in and Disagreements with  Accountants on Accounting and Financial Disclosure                            |   | 54     |
|          |   |                                                                                                                     |   |   |
|          |   | Item 9a. Controls and Procedures                                                                                         |   | 54     |
|          |   |                                                                                                                     |   |   |
|          |   | Item 9b. Other Information                                                                                               |   | 55     |
|          |   |                                                                                                                     |   |   |
| PART III |   |                                                                                                                     |   | 56     |
|          |   |                                                                                                                     |   |   |
|          |   | Item 10. Directors and Executive Officers  and Corporate Governance                                                      |   | 56     |
|          |   |                                                                                                                     |   |   |
|          |   | Item 11. Executive Compensation                                                                                          |   | 56     |
|          |   |                                                                                                                     |   |   |
|          |   | Item 12. Security Ownership of Certain  Beneficial Owners and Management and Related Stockholder Matters                 |   | 56     |
|          |   |                                                                                                                     |   |   |
|          |   | Item 13. Certain Relationships and Related  Transactions and Director Independence                                       |   | 56     |
|          |   |                                                                                                                     |   |   |
|          |   | Item 14. Principal Accountant Fees and  Services                                                                         |   | 56     |
|          |   |                                                                                                                     |   |   |
| PART IV  |   |                                                                                                                     |   | 56     |
|          |   |                                                                                                                     |   |   |
|          |   | Item 15. Exhibits, Financial Statement Schedules,  and Reports on Form 8-K                                          |   | 56     |
|          |   |                                                                                                                     |   |   |
| SIGNATURES    |   |                                                                                                                     | 60     |

 

----

Tableof Contents

 

**PART I**

 

**Item 1.****           Business**

 

**Forward Looking Statements**

 

Certain statements contained in this Annual Report on Form 10-Kthat are not statements of historical fact constitute forward-lookingstatements within the meaning of the Private Securities Litigation Reform Actof 1995 (the “Act”), notwithstanding that such statements are not specificallyidentified. These statements are basedon management’s beliefs and assumptions, and on information available tomanagement as of the date of this document. Forward-looking statements includethe information concerning possible or assumed future results of operations ofthe Company set forth under the heading “Management’s Discussion and Analysisof Financial Condition and Results of Operations.” Forward-looking statementsalso include statements in which words such as “expect,” “anticipate,” “intend,”“plan,” “believe,” “estimate,” “consider” or similar expressions are used.Forward-looking statements are not guarantees of future performance. Theyinvolve risks, uncertainties and assumptions, including the risks discussedunder the heading “Risk Factors” and elsewhere in this report. The Company’sactual future results and shareholder values may differ materially from thoseanticipated and expressed in these forward-looking statements. Many of thefactors that will determine these results and values, including those discussedunder the heading “Risk Factors That May Affect Results,” are beyond theCompany’s ability to control or predict. Investors are cautioned not to putundue reliance on any forward-looking statements. In addition, the Company doesnot have any intention or and assumes no obligation to update forward-lookingstatements after the date of the filing of this report, even if newinformation, future events or other circumstances have made such statementsincorrect or misleading. Except as specifically noted herein all referenced tothe “Company” refer to Community Valley Bancorp, a California corporation, andits consolidated subsidiaries.

 

**General**

 

**The Company**

 

Community Valley Bancorp (the “Company”) is aCalifornia corporation registered as a financial holding company under theBank  Holding Company Act of 1956, asamended (the “BHC Act”), and is headquartered in Chico, California. The Companywas incorporated in July, 2001 and acquired all of the outstanding shares ofButte Community Bank (the “Bank”) in May, 2002. The Company’s principalsubsidiary is the Bank. On July 10, 2007 the Company formed a wholly-ownedsubsidiary, Community Valley Bancorp Trust II (the “Trust”), which is aDelaware statutory business trust, for the purpose of issuing trust preferredsecurities. The proceeds from the Trust were used to redeem 100% of the trustpreferred securities issued by the 2002 Community Valley Bancorp Trust I.  After redemption Community Valley Trust I wasdissolved (see Note 9 to the Consolidated Financial Statements in Part II- Item 8).  The Company also has aninsurance subsidiary in the name of Butte Community Insurance Agency, LLC whichwas formed in December 2004 to provide a full service insurance agencyoffering all lines of coverage. The Company exists primarily for the purpose ofholding the stock of the Bank and of such other subsidiaries as it may acquireor establish.

 

In March 2008, the Company announced an offer to purchase up to1,000,000 shares of its common stock at a purchase price of $13.00.  A total of 1,572,907 shares of common stockwere tendered and the Company purchased a total of 999,939 shares for$12,999,000 at $13.00 per share representing a pro-rata share of the tenderedshares of 63.38%, on May 5, 2008.

 

The Company’s principal source of income is currently dividends fromthe Bank, but the Company intends to explore additional supplemental sources ofincome in the future. The expenditures of the Company, including (but not limitedto) the payment of dividends to shareholders, if and when declared by the Boardof Directors, and the cost of servicing debt will generally be paid from suchpayments made to the Company by the Bank.

 

At December 31, 2008, the Company had consolidated assets of$595.2 million, deposits of $526.5 million and shareholders’ equity of $40.1million.

 

The Company’s Administrative Offices are located at 1360 East LassenAvenue, Chico, California and its telephone number is (530) 899-2344.References herein to the “Company” include the Company and its subsidiaries,unless the context indicates otherwise.

 

The Companyfiles annual, quarterly and other reports under the Securities Exchange Act of1934 with the Securities and Exchange Commission. These reports are posted andare available at no cost on the Company’s website,www.communityvalleybancorp.com through the reports link, as soon as reasonablypracticable after the Company files such documents with the SEC. The Company’sfilings are also available through the SEC’s website at www.sec.gov.

 

3

----

Tableof Contents

 

**The Bank**

 

Butte Community Bank was incorporated under the laws of the State ofCalifornia on May 11, 1990 and commenced operations as a Californiastate-chartered commercial bank on December 14, 1990. The Bank’sAdministrative Office is located at 1360 East Lassen Avenue, Chico, California.The Bank is an insured bank under the Federal Deposit Insurance Act up to themaximum limits thereof and is participating in the separate FDIC TransactionAccount Guarantee Program.  Under thatprogram, through December 31, 2009, all noninterest-bearing transactionaccounts are fully guaranteed by the FDIC for the entire amount in theaccount.  The Bank is not a member of theFederal Reserve System. At December 31, 2008, the Bank had approximately$591.6 million in assets, $486.5 million in loans and $527.1 million indeposits.

 

We operate seven full-service branch offices in four Butte Countycommunities, one full-service branch office in Sutter County, two full-servicebranches in Tehama County, one full-service branch in Yuba County, onefull-service branch in Colusa County, three full-service branches in ShastaCounty, one Loan Production office in Sacramento County, and one LoanProduction office in Butte County. We offer a full range of banking services toindividuals and various-sized businesses in the communities we serve. Thelocations of those offices are:

 
| Chico:         |   | Main Office                                           |   | Paradise  |   | South Paradise Branch                    |
|----------------|--------|-------------------------------------------------------|--------|-----------|--------|------------------------------------------|
|           |   | 2041 Forest Avenue                                    |   |      |   | 672 Pearson Road                         |
|           |   |                                                  |   |      |   |                                     |
|           |   | Administrative Headquarters   1360 East Lassen Avenue |   |      |   | North Paradise Branch   6653 Clark Road  |
|           |   |                                                  |   |      |   |                                     |
|           |   | North Chico Branch                                    |   | Oroville  |   | Oroville Branch                          |
|           |   | 237 West East Avenue                                  |   |      |   | 2227 Myers Street                        |
|           |   |                                                  |   |      |   |                                     |
|           |   | Central Chico Branch                                  |   | Magalia   |   | Magalia Branch                           |
|           |   | 900 Mangrove Avenue                                   |   |      |   | 14001 Lakeridge Circle                   |
|           |   |                                                  |   |      |   |                                     |
| Citrus Heights |   | Citrus Heights Loan Office   5959 Greenback Lane#450  |   | Yuba City |   | Yuba City Branch   1600 Butte House Road |
|           |   |                                                  |   |      |   |                                     |
| Redding        |   | Redding Branch   2951 Churn Creek                     |   | Red Bluff |   | Red Bluff Branch   10 Gilmore Rd         |
|           |   |                                                  |   |      |   |                                     |
|           |   | Hilltop Branch   1335 Hilltop Drive                   |   | Anderson  |   | Anderson Branch   5026 Rhonda Road       |
|           |   |                                                  |   |      |   |                                     |
| Marysville     |   | Marysville Branch                                     |   | Colusa    |   | Colusa Branch                            |
|           |   | 904 B Street                                          |   |      |   | 1017 Bridge Street                       |
|           |   |                                                  |   |      |   |                                     |
| Gridley        |   | Gridley Loan Office                                   |   | Corning   |   | Corning Branch                           |
|           |   | 1010 Spruce Street                                    |   |      |   | 950 Hwy 99W                              |

 

In addition, our, Data Processing, Call Center and Bank Card Center arelocated at 1390 Ridgewood Drive, Chico. Our Real Estate Loan Center and CentralNote Department are located at 1360 East Lassen Avenue, Chico.  We also have specialized credit centers foragricultural lending and construction and real estate lending within a numberof these branch offices. These facilities are located in the cities of Chico,Paradise, and Oroville in Butte County, the city of Yuba City in Sutter County,The cities of Red Bluff and Corning in Tehama County, the city of Marysville inYuba County, the city of Colusa in Colusa County, the city of Citrus Heights inSacramento County, and the cities of Anderson and Redding in Shasta County.Throughout the history of Butte Community Bank, our growth has been exclusivelyby establishing de novo full-service branch offices and credit centers invarious locations in California’s Northern Sacramento Valley and foothillregion.  With a predominant focus onpersonal service, Butte Community Bank has positioned itself as amulti-community independent bank serving the financial needs of individuals andbusinesses, including agricultural and real estate customers in Butte and othersurrounding counties. Our principal retail lending services include home equityand consumer loans. In addition, we have three other significant dimensionswhich surround this core of retail community banking:  Agricultural lending, commercial lending, andreal estate financing (both construction and long term).

 

4

----

Tableof Contents

 

The Agricultural Credit Centers located in Yuba City, Chico, and RedBluff provide a complete line of credit services in support of the agriculturalactivities which are key to the continued economic development of thecommunities we serve. “Ag lending” clients include a full range of individualfarming customers and small business farming organizations.

 

The Bank CardCenter, headquartered in Chico, provides a range of credit, debit and ATM cardservices, which are made available to each of the customers served by thebranch banking offices. In addition, we staff our Chico, Paradise, Oroville,Red Bluff and Yuba City and Redding offices with real estate lendingspecialists. These officers are responsible for a complete line of landacquisition and development loans, construction loans for residential andcommercial development, and the origination of multifamily credit facilities.Secondary market services are provided through the Bank’s affiliations withFannie Mae and various non-governmental programs. The Bank servicesthese real estate loans sold on the secondary market, and as of year end 2008the portfolio serviced real estate loans was in excess of $9.3 million (in September 2007the portfolio of serviced loans was sold and in March 2008 the Bankresumed the retention of the servicing). We also have an orientation toward Small Business Administration lendingand have been designated as a Preferred Lender since 1998. The Bank’s SBAprogram generated approximately $2.1 million in loans during the past year. Itis anticipated that loans under this program will be an increasing segment ofour loan portfolio over the next few years. The Bank was also recognized as the fourth largest USDA Business andIndustry (B&I) Lender in the nation during 2008 based on the origination ofnineteen loans totaling more than $38 million. The primary purpose of the B&I program is to stimulate the local economy,create additional employment, attract additional commercial investment capitaland support potential growth in tax revenue, which will improve the quality oflife for rural residents.

 

As of December 31, 2008, the principal areas in which we directedour lending activities, and the percentage of our total loan portfolio forwhich each of these areas was responsible, were as follows: (i) agriculturalloans (6%); (ii) commercial and industrial (including SBA and B&I)loans (17%); (iii) real estate loans (commercial and construction) (64%); (iv) consumerloans (13%).

 

In addition to the lending activities noted above, we offer a widerange of deposit products for the retail banking market including checking,interest bearing transaction, savings, time certificates of deposit andretirement accounts, business sweep, Certificate of Deposit Account RegistryService (CDARS) as well as telephone banking and internet banking with bill payoptions. As of December 31, 2008, we had 40,808 deposit accounts withbalances totaling approximately $526 million, compared to 35,946 depositaccounts with balances totaling approximately $501 million at December 31,2007. Butte Community Bank attracts deposits through its customer-orientedproduct mix, competitive pricing, convenient locations, extended hours drive-upand on-line banking, all provided with the highest level of customer service.

 

We also offer other products and services to our customers, whichcomplement the lending and deposit services previously reviewed. These includecashier’s checks, traveler’s checks, bank-by-mail, ATM, night depository, safedeposit boxes, direct deposit, automated payroll services, cash management,lockbox, remote deposit capture and other customary banking services. SharedATM and Point of Sale (POS) networks allow customers access to the national andinternational funds transfer networks. We have one remote ATM which is locatedin a hospital and five script machines located in four different movie theatersand one restaurant. These locations facilitate cash advances which would nototherwise be available to consumers at non-branch locations, thereby increasingconsumer convenience. In addition to such specifically oriented customerapplications, we provide safe deposit, wire transfer capabilities and aconvenient customer service group in our Call Center to answer questions andassure a high level of customer satisfaction with the level of services andproducts we provide.  Most of the Bank’sdeposits are attracted from individuals, business-related sources and smallermunicipal entities. This results in a relatively modest average deposit balanceof approximately $12,400 at December 31, 2008, but makes the Bank lesssubject to adverse effects from the loss of a substantial depositor who may beseeking higher yields in other markets or who may have need of money otherwiseon deposit with the Bank, especially during periods of inflation orconservative monetary policies. The Bank has had a relationship with a localtitle company for many years. They have kept substantial deposit balances overthe years but beginning in 2007and continuing throughout 2008, with thedownturn in the real estate market, these balances decreased.

 

For non-deposit services, we have a strategic alliance with LinscoPrivate Ledger Financial Services. Through this arrangement, our registered andlicensed representatives provide Bank customers with convenient access toannuities, insurance products, mutual funds, and a full range of investmentproducts which are not FDIC insured. They conduct business from all of our fullservice offices.

 

We do not believe there is a significant demand for additional trustservices in our service areas, and we do not operate or have any presentintention to seek authority to operate a Trust Department. We believe that thecost of establishing and operating such a department would not be justified bythe potential income to be gained there from.

 

The officers and employees of the Bank are continually engaged inmarketing activities, including the evaluation and development of new productsand services, which enable the Bank to retain and improve its competitiveposition in its service area. All of these developments are meant to increasepublic convenience and enhance public access to the electronic payments system.The cost to the Bank for these development, implementation, and marketingactivities cannot expressly be calculated with any degree of certainty.

 

5

----

Table of Contents

 

The Bank holds no patents or licenses (other than licenses required byappropriate bank regulatory agencies), franchises, or concessions. The Bank isnot dependent on a single customer or group of related customers for a materialportion of its deposits, nor is a material portion of the Bank’s loansconcentrated within a single industry or group of related industries. There hasbeen no material effect upon the Bank’s capital expenditures, earnings, orcompetitive position as a result of Federal, state, or local environmentalregulation.

 

**Recent Developments**

 

During 2008 the Company completed the Tender Offer to purchase up to 1million shares of its common stock described above.  In addition, as a result of the declininginterest rates, the Company issued trust preferred securities (under CommunityValley Bancorp Trust II). The proceeds from the Trust were used in 2008 toredeem 100% of the trust preferred securities issued by the 2002 CommunityValley Bancorp Trust I.  After redemptionCommunity Valley Trust I was dissolved.

 

In February 2008, the Company sold and simultaneously entered intolong-term operating lease agreements on seven of its properties with proceedsfrom the sale of approximately $15.3 million and a net gain of $5.6 millionwhich has been deferred and will be recognized over the 15 year term of theleases.

 

OnDecember 31, 2008, Butte Community Bank signed a Letter of Intent to sellits merchant processing portfolio to Elavon (formerly known as NOVAInformation Systems).  In consideration for the merchant businessthrough the purchase of all interest in the Bank’s principal assets usedin its merchant credit card and debit card processing business, Elavon will paythe Bank $3,000,000 upon consummation of the acquisition. The Bank willcontinue to offer merchant processing business to our customers throughour marketing alliance with Elavon.  The sale is scheduled to closebefore the end of the first quarter 2009.

 

**Competition**

 

The banking business in California generally, and specifically in ourmarket areas, is highly competitive with respect to virtually all products andservices and has become increasingly more so in recent years. The industrycontinues to consolidate and strong, unregulated competitors have enteredbanking markets with focused products targeted at highly profitable customersegments. Many largely unregulated competitors are able to compete acrossgeographic boundaries and provide customers increasing access to meaningfulalternatives to banking services in nearly all significant products. Thesecompetitive trends are likely to continue.

 

With respect to commercial bank competitors, the business is largelydominated by a relatively small number of major banks with many officesoperating over a wide geographical area. These banks have, among other advantages, the ability to financewide-ranging and effective advertising campaigns and to allocate theirinvestment resources to regions of highest yield and demand. Many of the majorbanks operating in the area offer certain services which we do not offerdirectly but may offer indirectly through correspondent institutions. By virtueof their greater total capitalization, such banks also have substantiallyhigher lending limits than we do.

 

In addition to other banks, competitors include savings institutions,credit unions, and numerous non-banking institutions such as finance companies,leasing companies, insurance companies, brokerage firms, and investment bankingfirms. In recent years, increased competition has also developed fromspecialized finance and non-finance companies that offer wholesale finance,credit card, and other consumer finance services, including on-line bankingservices and personal finance software. Strong competition for deposit and loanproducts affects the rates of those products as well as the terms on which theyare offered to customers. Mergers between financial institutions have placedadditional pressure on banks within the industry to streamline theiroperations, reduce expenses, and increase revenues to remain competitive.Competition has also intensified due to recently enacted federal and stateinterstate banking laws, which permit banking organizations to expandgeographically, and the California market has been particularly attractive toout-of-state institutions. The Financial Modernization Act, which, effective March 11,2000, has made it possible for full affiliations to occur between banks andsecurities firms, insurance companies, and other financial companies, is alsoexpected to intensify competitive conditions.

 

Technological innovation has also resulted in increased competition infinancial services markets. Such innovation has, for example, made it possiblefor non-depository institutions to offer customers automated transfer paymentservices that previously have been considered traditional banking products. Inaddition, many customers now expect a choice of several delivery systems andchannels, including telephone, mail, home computer, remote deposit capture,ATMs, self service branches, and/or in-store branches. In addition to otherbanks, the sources of competition for such products include savingsassociations, credit unions, brokerage firms, money market and other mutualfunds, asset management groups, finance and insurance companies, internet-onlyfinancial intermediaries, and mortgage banking firms.

 

6

----

Table of Contents

 

For many years, we have countered this increasing competition byproviding our own style of community-oriented, personalized service. We relyupon local promotional activity, personal contacts by our officers, directors,employees, and shareholders, automated 24-hour banking, and the individualizedservice which we can provide through our flexible policies. In addition, tomeet the needs of customers with electronic access requirements, the Companyhas embraced the electronic age and installed telephone banking and personalcomputer and internet banking with bill payment capabilities. This high techand high touch approach allows the individual to customize the Bank’s contactmethodologies to their particular preference. MOREver, for customers whose loandemands exceed our legal lending limit, we attempt to arrange for such loans ona participation basis with correspondent banks. We also assist our customers inobtaining from our correspondent banks other services that the Bank may notoffer.

 

Our credit card business is subject to an even higher level ofcompetitive pressure than our general banking business. There are a number ofmajor banks and credit card issuers that are able to finance often highlysuccessful advertising campaigns with which community banks generally do nothave the resources to compete. As a result, our credit card balancesoutstanding are much more likely to increase at a slower rate than that whichmight be seen in nationwide issuers’ year-end statistics. Additionalcompetition comes from many non-financial institutions, such as providers ofvarious retail products, which offer many types of credit cards.

 

**Employees**

 

As of December 31, 2008 the Company had 168 full-timeand 110 part-time employees. On a full time equivalent basis, the Company’sstaff level was 248 at December 31, 2008, as compared to 260 at December 31,2007. None of our employees is concurrently represented by a union or coveredby a collective bargaining agreement. Management of the Company believes itsemployee relations are satisfactory.

 

**Regulation and Supervision**

 

The Company and the Bank are subject to significant regulation byfederal and state regulatory agencies. The following discussion of statutes andregulations is only a brief summary and does not purport to be complete. Thisdiscussion is qualified in its entirety by reference to such statutes andregulations. No assurance can be given that such statutes or regulations willnot change in the future.

 

**The Company**

 

The Company is a financial holding company within the meaning of theBank Holding Company Act of 1956 and is registered as such with the Board ofGovernors of the Federal Reserve System (the “Federal Reserve Board”). Afinancial holding company is required to file with the Federal Reserve Boardannual reports and other information regarding its business operations andthose of its subsidiaries. It is also subject to examination by the FederalReserve Board and is required to obtain Federal Reserve Board approval beforeacquiring, directly or indirectly, ownership or control of any voting shares ofany bank if, after such acquisition, it would directly or indirectly own orcontrol more than 5% of the voting stock of that bank, unless it already owns amajority of the voting stock of that bank.

 

The Federal Reserve Board has by regulation determined certainactivities in which a financial holding company may or may not conductbusiness. A financial holding company must engage, with certain exceptions, inthe business of banking or managing or controlling banks or furnishing servicesto or performing services for its subsidiary banks.

 

**The Bank**

 

As a California state-chartered bank whose accounts are insured by theFDIC, the Bank is subject to regulation, supervision and regular examination bythe Department of Financial Institutions (the “DFI”) and the FDIC. In addition,while the Bank is not a member of the Federal Reserve System, it is subject tocertain regulations of the Federal Reserve Board. The regulations of theseagencies govern most aspects of the Bank’s business, including the making ofperiodic reports by the Bank, and the Bank’s activities relating to dividends,investments, loans, borrowings, capital requirements, certain check-clearingactivities, branching, mergers and acquisitions, reserves against deposits andnumerous other areas. Supervision, legal action and examination of the Bank bythe FDIC are generally intended to protect depositors and are not intended forthe protection of shareholders.

 

7

----

Tableof Contents

 

The earnings and growth of the Bank are largely dependent on itsability to maintain a favorable differential or “spread” between the yield onits interest-earning assets and the rate paid on its deposits and otherinterest-bearing liabilities. As a result, the Bank’s performance is influencedby general economic conditions, both domestic and foreign, the monetary andfiscal policies of the federal government, and the policies of the regulatoryagencies, particularly the Federal Reserve Board. The Federal Reserve Boardimplements national monetary policies (such as seeking to curb inflation andcombat recession) by its open-market operations in United States Governmentsecurities, by adjusting the required level of reserves for financialinstitutions subject to its reserve requirements and by varying the discountrate applicable to borrowings by banks which are members of the Federal ReserveSystem. The actions of the Federal Reserve Board in these areas influence thegrowth of bank loans, investments and deposits and also affect interest ratescharged on loans and deposits. In addition, the US government has passedlegislation designed to stimulate the economy and stabilize the financial andhousing markets. Further discussion is found later under Recent Legislation andOther Changes.  The nature andimpact of any future changes in monetary policies cannot be predicted.

 

**Capital Adequacy Requirements**

 

The Company and the Bank are subject to the regulations of the FederalReserve Board and the FDIC, respectively, governing capital adequacy. Thoseregulations incorporate both risk-based and leverage capital requirements. Eachof the federal regulators has established risk-based and leverage capitalguidelines for the banks or bank holding companies it regulates, which settotal capital requirements and define capital in terms of “core capitalelements,” or Tier 1 capital; and “supplemental capital elements,” or Tier 2capital. Tier 1 capital is generally defined as the sum of the core capitalelements less goodwill and certain other deductions, notably the unrealized netgains or losses (after tax adjustments) on available for sale investmentsecurities carried at fair market value. The following items are defined ascore capital elements: (i) common shareholders’ equity; (ii) trustpreferred securities are a form of long-term borrowing that currently qualifiesas Tier 1 capital not to exceed 25% of pro-forma Tier 1 capital; (iii) qualifyingnon-cumulative perpetual preferred stock and related surplus (not to exceed 25%of pro-forma Tier 1 capital); and (iv) minority interests in the equityaccounts of consolidated subsidiaries. Supplementary capital elementsinclude:  (i) allowance for loan andlease losses (but not more than 1.25% of an institution’s risk-weightedassets); (ii) perpetual preferred stock and related surplus not qualifyingas core capital; (iii) hybrid capital instruments, perpetual debt andmandatory convertible debt instruments; and (iv) term subordinated debtand intermediate-term preferred stock and related surplus. The maximum amountof supplemental capital elements which qualifies as Tier 2 capital is limitedto 100% of Tier 1 capital, net of goodwill.

 

The minimum required ratio of qualifying total capital to totalrisk-weighted assets is 8.0% (“Total Risk-Based Capital Ratio”), at least onehalf of which must be in the form of Tier 1 capital, and the minimum requiredratio of Tier 1 capital to total risk-weighted assets is 4.0% (“Tier 1Risk-Based Capital Ratio”). Risk-based capital ratios are calculated to providea measure of capital that reflects the degree of risk associated with a bankingorganization’s operations for both transactions reported on the balance sheetas assets, and transactions, such as letters of credit and recoursearrangements, which are recorded as off-balance sheet items. Under therisk-based capital guidelines, the nominal dollar amounts of assets andcredit-equivalent amounts of off-balance sheet items are multiplied by one ofseveral risk adjustment percentages, which range from 0% for assets with lowcredit risk, such as certain U. S. Treasury securities, to 100% for assets withrelatively high credit risk, such as business loans. As of December 31, 2008and 2007, the Bank’s Total Risk-Based Capital Ratios were 10.4% and 11.4%,respectively and its Tier 1 Risk-Based Capital Ratios were 9.1% and 10.4%,respectively. As of December 31, 2008 and 2007, the Company’s TotalRisk-Based Capital was 10.0% and 14.1% respectively, and its Tier 1 Risk-BasedCapital Ratio was 8.8% and 13.1% respectively. While the Company and the Bankcontinue to meet all of their regulatory capital requirements, the primaryreason for the decrease in both the Company’s and the Bank’s ratios was theresult of the tender offer completed in 2008. The risk-based capitalrequirements also take into account concentrations of credit (i.e., relativelylarge proportions of loans involving one borrower, industry, location,collateral or loan type) and the risks of “non-traditional” activities (thosethat have not customarily been part of the banking business). The regulationsrequire institutions with high or inordinate levels of risk to operate withhigher minimum capital standards, and authorize the regulators to review aninstitution’s management of such risks in assessing an institution’s capitaladequacy.

 

The risk-based capital regulations also include exposure to interestrate risk as a factor that the regulators will consider in evaluating a bank’scapital adequacy. Interest rate risk is the exposure of a bank’s current andfuture earnings and equity capital arising from adverse movements in interestrates. While interest risk is inherent in a bank’s role as financialintermediary, it introduces volatility to bank earnings and to the economicvalue of the bank.

 

The FDIC and the Federal Reserve Board also require the maintenance ofa leverage capital ratio designed to supplement the risk-based capitalguidelines. Banks and bank holding companies that have received the highestrating of the five categories used by regulators to rate banks and are notanticipating or experiencing any significant growth must maintain a ratio ofTier 1 capital (net of all intangibles) to adjusted total assets (“LeverageCapital Ratio”) of at least 3%. All other institutions are required to maintaina leverage ratio of at least 100 to 200 basis points above the 3% minimum, fora minimum of 4% to 5%. Pursuant to federal regulations, banks must maintaincapital levels commensurate with the level of risk to which they are exposed,including the volume and severity of problem loans, and federal regulators may,however, set higher capital requirements when a bank’s particular circumstanceswarrant. As of December 31, 2008 and 2007, the Bank’s Leverage CapitalRatios were 8.2% and 9.3%, respectively.

 

8

----

Table of Contents

 

As of December 31, 2008 and 2007, the Company’s leverage capitalratios were 8.1% and 11.6%, respectively, exceeding regulatory minimums. At December 31,2008 and 2007 the Company met all of its capital adequacy guidelines and theBank was considered “well capitalized” under the prompt corrective actionprovisions. See Part II, Item 7, Management’s Discussion and Analysis ofFinancial Condition and Results of Operation — Liquidity and Market RiskManagement.

 

**Prompt Corrective Action Provisions**

 

Federal law requires each federal banking agency to take promptcorrective action to resolve the problems of insured financial institutions,including but not limited to those that fall below one or more prescribedminimum capital ratios. The federal banking agencies have by regulation definedthe following five capital categories: “well capitalized” (Total Risk-BasedCapital Ratio of 10%; Tier 1 Risk-Based Capital Ratio of 6%; and Leverage Ratioof 5%); “adequately capitalized” (Total Risk-Based Capital Ratio of 8%; Tier 1Risk-Based Capital Ratio of 4%; and Leverage Ratio of 4%) (or 3% if theinstitution receives the highest rating from its primary regulator); “undercapitalized”(Total Risk-Based Capital Ratio of less than 8%; Tier 1 Risk-Based CapitalRatio of less than 4%; or Leverage Ratio of less than 4%) (or 3% if theinstitution receives the highest rating from its primary regulator); “significantlyundercapitalized” (Total Risk-Based Capital Ratio of less than 6%; Tier 1Risk-Based Capital Ratio of less than 3%; or Leverage Ratio less than 3%); and “criticallyundercapitalized” (tangible equity to total assets less than 2%). A bank may betreated as though it were in the next lower capital category if after noticeand the opportunity for a hearing, the appropriate federal agency finds anunsafe or unsound condition or practice so warrants, but no bank may be treatedas “critically undercapitalized” unless its actual capital ratio warrants suchtreatment.

 

At each successively lower capital category, an insured bank is subjectto increased restrictions on its operations. For example, a bank is generallyprohibited from paying management fees to any controlling persons or frommaking capital distributions if to do so would make the bank “undercapitalized.”  Asset growth and branching restrictions applyto undercapitalized banks, which are required to submit written capitalrestoration plans meeting specified requirements (including a guarantee by theparent holding company, if any). “Significantly undercapitalized” banks aresubject to broad regulatory authority, including among other things, capitaldirectives, forced mergers, restrictions on the rates of interest they may payon deposits, restrictions on asset growth and activities, and prohibitions onpaying certain bonuses without FDIC approval. Even more severe restrictionsapply to critically undercapitalized banks. Most importantly, except underlimited circumstances, not later than 90 days after an insured bank becomescritically undercapitalized, the appropriate federal banking agency is requiredto appoint a conservator or receiver for the bank.

 

In addition to measures taken under the prompt corrective actionprovisions, insured banks may be subject to potential actions by the federalregulators for unsafe or unsound practices in conducting their businesses orfor violations of any law, rule, regulation or any condition imposed in writingby the agency or any written agreement with the agency. Enforcement actions mayinclude the issuance of cease and desist orders, termination of insurance ofdeposits (in the case of a bank), the imposition of civil money penalties, theissuance of directives to increase capital, formal and informal agreements, orremoval and prohibition orders against “institution-affiliated” parties.

 

**Safety and Soundness Standards**

 

The federal banking agencies have also adopted guidelines establishingsafety and soundness standards for all insured depository institutions. Thoseguidelines relate to internal controls, information systems, internal auditsystems, loan underwriting and documentation, compensation and interest rateexposure. In general, the standards are designed to assist the federal bankingagencies in identifying and addressing problems at insured depositoryinstitutions before capital becomes impaired. If an institution fails to meetthese standards, the appropriate federal banking agency may require theinstitution to submit a compliance plan and institute enforcement proceedingsif an acceptable compliance plan is not submitted.

 

**Premiums for Deposit Insurance**

 

The FDIC merged the Bank Insurance Fund (BIF) and the SavingsAssociation Insurance Fund (SAIF) to form the Deposit Insurance Fund (DIF) on March 31,2006 in accordance with the Federal Deposit Insurance Reform Act of 2005. As aresult of the merger of the BIF and SAIF, all insured institutions are subjectto the same assessment rate schedule. The amount each institution is assessedis based upon statutory factors that include the balance of insured deposits aswell as the degree of risk the institution poses to the insurance fund.The FDIC approved final rules to determine risk-based assessment rates on November 2,2006, with rates effective on January 1, 2007, however new rules wereproposed in 2008.  An insured depositoryinstitution’s assessment rate under the final rule is based on the newassessment rate schedule, its long-term debt issuer ratings or recent financialratios and supervisory ratings.  Theproposed rules would also look at other factors that increase risks to theFDIC’s insurance fund.  These increasesin assessments or the assessment rate could have a material adverse effect onour business, financial condition, results of operations or cash flows,depending on the amount of the increase. Furthermore, the FDIC is authorized to raise insurance premiums undercertain circumstances and on February 27, 2009, passed an interim rule thatallows it to charge banks a special assessment of 20 basis points (bps) oninsured deposits to replenish the deposit insurance fund. This special assessmentwill be collected in the third quarter of 2009.

 

9

----

Table of Contents

 

****Since January of 2007******,**the previous nine risk classifications (the risk-basedassessment matrix) were consolidated into four risk categories. However,capital ratios and supervisory ratings continue to distinguish risk categories.The following table shows the relationship between the old nine-cell matrix andthe new risk categories as well as the initial assessment rates for each newrisk category. Supervisory Group A generally include institutions with CAMELScomposite ratings of 1 or 2; Supervisory Group B generally includesinstitutions with a CAMELS composite rating of 3; and Supervisory Group Cgenerally includes institutions with CAMELS composite ratings of 4 or 5.  The current DIF base assessment rates(expressed as cents per $100 of deposits) are summarized as follows:

 
| ** **             | ** ** | **Supervisory Group** | ** ** |
|------------------------|------------|----------------------------|------------|
| **Capital Group** | ** ** | **A**                      | ** ** | **B** | ** ** | **C** | ** ** |
| ** **             | ** ** | **I**                      | ** ** | **II** | ** ** | **III** | ** ** |
| Well Capitalized       | ** ** | **5-7**                    | ** ** | **10** | ** ** | **28** | ** ** |
| Adequately Capitalized |       |                       |       |   |   |   |   |
| ** **             | ** ** | **III**                    | ** ** | **IV** | ** ** |
| Undercapitalized       | ** ** | **28**                     | ** ** | **43** | ** ** |

 

**Dividends**

 

The Company is entitled to receive dividends, when and as declared byits subsidiary banks’ Boards of Directors. Those dividends may come from fundslegally available for those dividends, as specified and limited by theCalifornia Financial Code and the U.S. Code. Under the California FinancialCode, funds available for cash dividends by a California-chartered bank arerestricted to the lesser of:(i) the bank’s retained earnings; or (ii) thebank’s net income for its last three fiscal years (less any distributions toshareholders made during such period). With the prior approval of theCalifornia Department of Financial Institutions (“DFI”), cash dividends mayalso be paid out of the greater of: (i) the bank’s retained earnings; (ii) netincome for the bank’s last preceding fiscal year; or (iii) net income forthe bank’s current fiscal year. If the DFI determines that the shareholders’equity of the bank paying the dividend is not adequate or that the payment ofthe dividend would be unsafe or unsound for the bank, the DFI may order thebank not to pay the dividend. It is also possible, depending upon its financialcondition and other factors, that a regulatory agency could assert that thepayment of dividends or other payments might, under some circumstances,constitute an unsafe or unsound practice and thereby prohibit such payments.

 

California Corporations Code Section 500 allows the Company to paya dividend to its shareholders only to the extent that it has retained earningsand, after the dividend, its:

 

·                  assets (exclusive of goodwill and otherintangible assets) would be 1.25 times its liabilities (exclusive of deferredtaxes, deferred income and other deferred credits); and

 

·                  current assets would be at least equal tocurrent liabilities.

 

Additionally, the FRB’s policy regarding dividends provides that a bankholding company should not pay cash dividends exceeding its net income or whichcan only be funded in ways that weaken the bank holding company’s financialhealth, such as by borrowing. The FRB also possesses enforcement powers overbank holding companies and their non-bank subsidiaries to prevent or remedyactions that represent unsafe or unsound practices or violations of applicablestatutes and regulations.

 

In addition the Company’s ability to pay dividends is subject tocertain covenants contained in the indentures relating to Trust PreferredSecurities issued by CVB Trust II.

 

**Transactions with Affiliates**

 

The Company and any of its subsidiaries and certain related interestsare deemed to be affiliates of its subsidiary banks within the meaning ofSections 23A and 23B of the Federal Reserve Act. Under those terms, loans by asubsidiary bank to affiliates, investments by them in affiliates’ stock, andtaking affiliates’ stock as collateral for loans to any borrower is limited to10% of the particular banking subsidiary’s capital, in the case of any oneaffiliate, and is limited to 20% of the banking subsidiary’s capital, in thecase of all affiliates. In addition, such transactions must be on terms andconditions that are consistent with safe and sound banking practices; inparticular, a bank and its subsidiaries generally may not purchase from anaffiliate a low-quality asset, as defined in the Federal Reserve Act. Theserestrictions also prevent a bank holding company and its other affiliates fromborrowing from a banking subsidiary of the bank holding company unless theloans are secured by marketable collateral of designated amounts. The Companyand its subsidiary banks are also subject to certain restrictions with respectto engaging in the underwriting, public sale and distribution of securities.

 

10

----

Tableof Contents

 

**Interstate Banking and Branching**

 

The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994(the “Interstate Banking Act”) regulates the interstate activities of banks andbank holding companies and establishes a framework for nationwide interstatebanking and branching. Since June 1, 1997, a bank in one state hasgenerally been permitted to merge with a bank in another state without the needfor explicit state law authorization. However, states were given the ability toprohibit interstate mergers with banks in their own state by “opting-out”(enacting state legislation applying equality to all out-of-state banksprohibiting such mergers) prior to June 1, 1997.

 

Since 1995, adequately capitalized and managed bank holding companieshave been permitted to acquire banks located in any state, subject to twoexceptions: first, any state may still prohibit bank holding companies fromacquiring a bank which is less than five years old; and second, no interstateacquisition can be consummated by a bank holding company if the acquirer wouldcontrol more than 10% of the deposits held by insured depository institutionsnationwide or 30% percent or more of the deposits held by insured depositoryinstitutions in any state in which the target bank has branches.

 

A bank may establish and operate de novo branches in any state in whichthe bank does not maintain a branch if that state has enacted legislation toexpressly permit all out-of-state banks to establish branches in that state.

 

In 1995 California enacted legislation to implement importantprovisions of the Interstate Banking Act discussed above and to repealCalifornia’s previous interstate banking laws, which were largely preempted bythe Interstate Banking Act.

 

The changes effected by Interstate Banking Act and California laws haveincreased competition in the environment in which the Bank operates to theextent that out-of-state financial institutions directly or indirectly enterthe Bank’s market areas. It appears that the Interstate Banking Act hascontributed to the accelerated consolidation of the banking industry. Whilemany large out-of-state banks have already entered the California market as aresult of this legislation, it is not possible to predict the precise impact ofthis legislation on the Bank and the Company and the competitive environment inwhich they operate.

 

**Federal Reserve System. **The FRBrequires all depository institutions to maintain non-interest bearing reservesat specified levels against their transaction accounts and non-personal timedeposits.  At December 31, 2008, wewere in compliance with these requirements.

 

**Impact of Monetary Policies. **The earningsand growth of the Company are subject to the influence of domestic and foreigneconomic conditions, including inflation, recession and unemployment.  The earnings of the Company are affected notonly by general economic conditions but also by the monetary and fiscalpolicies of the United States and federal agencies, particularly the FRB.  The FRB can and does implement nationalmonetary policy, such as seeking to curb inflation and combat recession, by itsopen market operations in United States Government securities and by its controlof the discount rates applicable to borrowings by banks from the FRB.  The actions of the FRB in these areasinfluence the growth of bank loans and leases, investments and deposits andaffect the interest rates charged on loans and leases and paid on deposits.  The FRB’s policies have had a significanteffect on the operating results of commercial banks and are expected tocontinue to do so in the future.  Thenature and timing of any future changes in monetary policies are not predictable.

 

**Consumer Protection Laws and Regulations. **The banking regulatory agencies are focusing greater attention oncompliance with consumer protection laws and their implementingregulations.  Examination and enforcementhave become more intense in nature, and insured institutions have been advisedto monitor carefully compliance with such laws and regulations.  The Company is subject to many federal andstate consumer protection and privacy statutes and regulations, some of whichare discussed below.

 

The*Community Reinvestment Act* (the “CRA”) is intended toencourage insured depository institutions, while operating safely and soundly,to help meet the credit needs of their communities.  The CRA specifically directs the federalregulatory agencies, in examining insured depository institutions, to assess abank’s record of helping meet the credit needs of its entire community,including low- and moderate-income neighborhoods, consistent with safe andsound banking practices.  The CRA furtherrequires the agencies to take a financial institution’s record of meeting itscommunity credit needs into account when evaluating applications for, amongother things, domestic branches, mergers or acquisitions, or holding companyformations**. **Inmeasuring a bank’s compliance with its CRA obligations, the regulators utilizea performance-based evaluation system which bases CRA ratings on the bank’sactual lending service and investment performance, rather than on the extent towhich the institution conducts needs assessments, documents community outreachactivities or complies with other procedural requirements. The agencies use the CRA assessment factorsin order to provide a rating to the financial institution.  The ratings range from a high of “outstanding”to a low of “substantial noncompliance.” In its last examination for CRA compliance, as of February 2007,the Bank was rated “satisfactory.”

 

11

----

Table of Contents

 

The*Equal Credit Opportunity Act* (the “ECOA”) generallyprohibits discrimination in any credit transaction, whether for consumer orbusiness purposes, on the basis of race, color, religion, national origin, sex,marital status, age (except in limited circumstances), receipt of income frompublic assistance programs, or good faith exercise of any rights under theConsumer Credit Protection Act.

 

The*Truth in Lending Act* (the “TILA”) is designed to ensurethat credit terms are disclosed in a meaningful way so that consumers maycompare credit terms more readily and knowledgeably.  As a result of the TILA, all creditors mustuse the same credit terminology to express rates and payments, including theannual percentage rate, the finance charge, the amount financed, the total ofpayments and the payment schedule, among other things.

 

The*Fair Housing Act* (the “FH Act”) regulates many practices,including making it unlawful for any lender to discriminate in itshousing-related lending activities against any person because of race, color,religion, national origin, sex, handicap or familial status.  A number of lending practices have been foundby the courts to be, or may be considered, illegal under the FH Act, includingsome that are not specifically mentioned in the FH Act itself.

 

The*Home Mortgage Disclosure Act* (the “HMDA”), in response topublic concern over credit shortages in certain urban neighborhoods, requirespublic disclosure of information that shows whether financial institutions areserving the housing credit needs of the neighborhoods and communities in whichthey are located.  The HMDA also includesa “fair lending” aspect that requires the collection and disclosure of dataabout applicant and borrower characteristics as a way of identifying possiblediscriminatory lending patterns and enforcing anti-discrimination statutes.

 

The*Right to Financial Privacy Act* (the “RFPA”)imposes a new requirement for financial institutions to provide new privacyprotections to consumers.  Financialinstitutions must provide disclosures to consumers of its privacy policy, andstate the rights of consumers to direct their financial institution not toshare their nonpublic personal information with third parties.

 

Finally,the *Real Estate Settlement Procedures Act*(the “RESPA”) requires lenders to provide noncommercial borrowers withdisclosures regarding the nature and cost of real estate settlements.  Also, RESPA prohibits certain abusivepractices, such as kickbacks, and places limitations on the amount of escrowaccounts.

 

Penaltiesfor noncompliance or violations under the above laws may include fines,reimbursement and other penalties.  Dueto heightened regulatory concern related to compliance with CRA, ECOA, TILA, FHAct, HMDA, RFPA and RESPA generally, the Company may incur additionalcompliance costs or be required to expend additional funds for investments inits local community.

 

**Changes in Legislation and Regulation of Financial Institutions**

 

We are subject to extensive government regulation, which may impact ourability to increase our assets and earnings. Banking operations are subject to regulation by federal and state andgovernmental authorities and are subject to various laws and judicial andadministrative decisions imposing requirements and restrictions on part or allof our operations.  Because our businessis highly regulated, the laws, rules, regulations and supervisory guidance andpolicies applicable to us are subject to regular modification and change.  In addition, various laws, rules and regulationsare periodically proposed, which, if adopted, could impact our operations bymaking compliance much more difficult or expensive, restricting our ability tooriginate or sell loans or further restricting our ability to originate or sellloans or further restricting the amount of interest or other charges or feesearned on loans or other products.

 

**Recent Legislation and Other Changes **Federal and state laws affecting banking are enacted from time to time,and similarly federal and state regulations affecting banking are also adoptedfrom time to time.  The following includesome of the recent laws and regulations affecting banking.

 

OnFebruary 17, 2009, the American Recovery and Reinvestment Act of 2009 (“ARRA”)was enacted to provide stimulus to the struggling US economy.  ARRA authorizes spending of $787 billion,including approximately $288 billion for tax relief, $144 billion for state andlocal relief aid, and $111 billion for infrastructure and science.  In addition, ARRA includes additional executivecompensation restrictions for recipients of funds from the US Treasury underthe Troubled Assets Relief

 

12

----

Tableof Contents

 

Programof the Emergency Economic Stimulus Act of 2008 (“EESA”).  The provisions of EESA amended by the ARRAinclude (i) expanding the coverage of the executive compensation limits toas many as the 25 most highly compensated employees of a TARP funds recipientand its affiliates for certain aspects of executive compensation limits and (ii) specificallylimiting incentive compensation of covered executives to one-third of theirannual compensation which is required to be paid in restricted stock that doesnot vest until all of the TARP funds are no longer outstanding (note that ifTARP warrants remain outstanding and no other TARP instruments are outstanding,then such warrants would not be considered outstanding for purposes of thisincentive compensation restriction). In addition, the board ofdirectors of any TARP recipient is required under EESA, as amended to have acompany-wide policy regarding excessive or luxury expenditures, as identifiedby the Treasury, which may include excessive expenditures on entertainment orevents; office and facility renovations; aviation or other transportationservices; or other activities or events that are not reasonable expendituresfor staff development, reasonable performance incentives, or other similarmeasures conducted in the normal course of the business operations of the TARPrecipient.

 

EESA,as amended by ARRA, provides for a new incentive compensation restriction forfinancial institutions receiving TARP funds. The number of executives and employees covered by this new incentivecompensation restriction depends on the amount of TARP funds received by suchentity.  For community banks that have orwill receive less than $25 million, the new incentive compensation restrictionapplies only to the highest paid employee. This new incentive compensationrestriction prohibits a TARP recipient from paying or accruing any bonus,retention award, or incentive compensation during the period in which any TARPobligation remains outstanding, except that such prohibition shall not apply tothe payment of long-term restricted stock by such TARP recipient, provided thatsuch long-term restricted stock (i) does not fully vest during the periodin which any TARP obligation remains outstanding, (ii) has a value in anamount that is not greater than 1/3 of the total amount of annual compensationof the employee receiving the stock; and (iii) is subject to such otherterms and conditions as the Secretary of the Treasury may determine is in thepublic interest.  In addition, this prohibitiondoes not prohibit any bonus payment required to be paid pursuant to a writtenemployment contract executed on or before February 11, 2009, as such validemployment contracts are determined by the Treasury.

 

EESAwas amended by ARRA to also provide additional corporate governance provisionswith respect to executive compensation including the following:

 

·                  ESTABLISHMENTOF STANDARDS - During the period in which any TARP obligation remainsoutstanding, each TARP recipient shall be subject to the standards in theregulations issued by the Treasury with respect to executive compensationlimitations for TARP recipients, and the provisions of section 162(m) (5) ofthe Internal Revenue Code of 1986, as applicable (nondeductibility of executivecompensation in excess of $500,000).

 

·                  COMPLIANCEWITH STANDARDS - The Treasury is required to see that each TARP recipient meetthe required standards for executive compensation and corporate governance.

 

·                  SPECIFICREQUIREMENTS FOR THE REQUIRED STANDARDS -

 

·                  Limitson compensation that exclude incentives for senior executive officers of theTARP recipient to take unnecessary and excessive risks that threaten the valueof the financial institution during the period in which any TARP obligationremains outstanding.

 

·                  Aclawback requirement by such TARP recipient of any bonus, retention award, orincentive compensation paid to a senior executive officer and any of the next20 most highly-compensated employees of the TARP recipient based on statementsof earnings, revenues, gains, or other criteria that are later found to bematerially inaccurate.

 

·                  Aprohibition on such TARP recipient making any golden parachute payment to asenior executive officer or any of the next 5 most highly-compensated employeesof the TARP recipient during the period in which any TARP obligation remainsoutstanding.

 

·                  Aprohibition on any compensation plan that would encourage manipulation of thereported earnings of such TARP recipient to enhance the compensation of any ofits employees.

 

·                  Arequirement for the establishment of an independent Compensation Committee thatmeets at least twice a year to discuss and evaluate employee compensation plansin light of an assessment of any risk posed to the TARP recipient from suchplans.  For a non SEC company that is aTARP recipient that has received $25,000,000 or less of TARP assistance, theduties of the compensation committee may be carried out by the board ofdirectors of such TARP recipient.

 

13

----

Table of Contents

 

Inaddition, EESA as amended by ARRA provides that for any TARP recipient, itsannual meeting materials shall include a nonbinding shareholder approvalproposal of executive compensation for shareholders to vote.  The SEC is to establish regulations toimplement this provision.  Whilenonpublic companies are required to include this proposal, it is not known whatthe regulations will provide as to executive compensation disclosurerequirements of such TARP recipients, and whether they will be as extensive asthe existing SEC executive compensation requirements.  In addition, shareholders are allowed topresent other nonbinding proposals with respect to executive compensation.

 

OnFebruary 10, 2009, the U. S. Treasury, the Federal Reserve Board, theFederal Deposit Insurance Corporation, the Office of the Comptroller of theCurrency, and the Office of Thrift Supervision are announced a comprehensiveset of measures to restore confidence in the strength of U.S. financialinstitutions and restart the critical flow of credit to households andbusinesses.  This program is intended torestore the flows of credit necessary to support recovery.

 

Thecore program elements include:

 

·                  Anew Capital Assistance Program to help ensure that our banking institutionshave sufficient capital to withstand the challenges ahead, paired with asupervisory process to produce a more consistent and forward-looking assessmentof the risks on banks’ balance sheets and their potential capital needs.

 

·                  Anew Public-Private Investment Fund on an initial scale of up to $500 billion,with the potential to expand up to $1 trillion, to catalyze the removal oflegacy assets from the balance sheets of financial institutions. This fund willcombine public and private capital with government financing to help free upcapital to support new lending.

 

·                  Anew Treasury and Federal Reserve initiative to dramatically expand – up to $1trillion – the existing Term Asset-Backed Securities Lending Facility (TALF) inorder to reduce credit spreads and restart the securitized credit markets thatin recent years supported a substantial portion of lending to households,students, small businesses, and others.

 

·                  Anextension of the FDIC’s Temporary Liquidity Guarantee Program to October 31,2009. A new framework of governance and oversight to help ensure that banksreceiving funds are held responsible for appropriate use of those funds throughstronger conditions on lending, dividends and executive compensation along withenhanced reporting to the public.

 

InOctober 2008, the President signed the Emergency Economic Stabilization Act of 2008 (“EESA”), commonlyreferred to as the bailout bill in response to the global financial crisis of2008 authorizing the United States Secretary of the Treasury with authority tospend up to $700 billion to purchase distressed assets, especiallymortgage-backed securities, under the Troubled Assets Relief Program (“TARP”) and make capital injections into banksunder the Capital Purchase Program.  EESA gives the government the unprecedentedauthority to buy troubled assets on balance sheets of financial institutionsunder the Troubled Assets Relief Program and increases the limit on insureddeposits from $100,000 to $250,000 until December 31, 2009.  Some of the other provisions of EESA are asfollows:

 

·                  acceleratedfrom 2011 to 2008 the date that the Federal Reserve Bank could pay interest ondeposits of banks held with the Federal Reserve to meet reserve requirements;

 

·                  tothe extent that the U. S. Treasury purchases mortgage securities as part of TARP,the Treasury shall implement a plan to minimize foreclosures including usingguarantees and credit enhancements to support reasonable loan modifications,and to the extent loans are owned by the government to consent to thereasonable modification of such loans;

 

·                  limitsexecutive compensation for executives for TARP participating financialinstitutions including a maximum corporate tax deduction limit of $500,000 foreach of the top five highest paid executives of such institution, requiringclawbacks of incentive compensation that were paid based on inaccurate or falseinformation, limiting golden parachutes for involuntary and certain voluntaryterminations to 2.99x their average annual salary and bonus for the last fiveyears, and prohibiting the payment of incentive compensation that encouragesmanagement to take unnecessary and excessive risks with respect to theinstitution;

 

14

----

Table of Contents

 

·                  extendsthe mortgage debt forgiveness provision of the Mortgage Forgiveness Debt ReliefAct of 2007 by three years (2012) to ease the income tax burden on thoseinvolved with certain foreclosures; and

 

·                  qualified financial institutions may count losseson FNMA and FHLMC preferred stock against ordinary income, rather than capitalgain income.

 

TheTemporary Liquidity Guarantee Program was implemented by the FDIC on October 14,2008 to mitigate the lack of liquidity in the financial markets.  The Temporary Liquidity Guarantee Program hastwo primary components: the Debt Guarantee Program, by which the FDIC willguarantee the payment of certain newly-issued senior unsecured debt, and theTransaction Account Guarantee Program, by which the FDIC will guarantee certainnoninterest-bearing transaction accounts. The Debt Guarantee Program provides for an FDIC guarantee as to thepayment of all senior unsecured debt (with a term of more than 30 days) issuedby a qualified participating entity (insured depository institutions, bank andfinancial holding companies, and certain savings and loan holding companies) upto a limit of 125 percent of all senior unsecured debt outstanding on September 30,2008, and maturing by June 30, 2009. The FDIC guarantee is until June 30, 2012, and the fee for suchguarantee depends on the term with a maximum of 100 basis points for terms inexcess of 365 days.  The TransactionAccount Guarantee Program is the second part of the FDIC’s Temporary LiquidityGuarantee Program.  The FDIC provides fora temporary full guarantee held at a participating FDIC-insured depositoryinstitution of noninterest-bearing transaction accounts above the existingdeposit insurance limit at the additional cost of 10 basis points perannum.  This coverage became effective onOctober 14, 2008, and would continue through December 31, 2009.  The Company and the Bank elected toparticipate in the Transactional Account Guarantee Program.

 

On July 30, 2008, the Housing and Economic Recovery Act was was signed by PresidentBush.  It authorizes the Federal Housing Administration to guarantee up to$300 billion in new 30-year fixed rate mortgages for subprime borrowers iflenders write-down principal loan balances to 90 percent of current appraisalvalue.  It is also intended to restoreconfidence in Fannie Mae and Freddie Mac by strengthening regulations andinjecting capital into them.  States willbe authorized to refinance subprime loans using mortgage revenue bonds.  It also establishes the Federal HousingFinance Agency (FHFA) out of the Federal Housing Finance Board (FHFB) andOffice of Federal Housing Enterprise Oversight (OFHEO).

 

In 2008, the Federal ReserveBoard, the Federal Deposit Insurance Corporation, the Office of the Comptrollerof the Currency, and the Office of Thrift Supervision amended their regulatory capital rules to permit banks, bank holdingcompanies, and savings associations (as to any of these a “financialinstitution”) to reduce the amount of goodwill that a banking organization mustdeduct from tier 1 capital by the amount of any deferred tax liabilityassociated with that goodwill.  However,a financial institution that reduces the amount of goodwill deducted from tier1 capital by the amount of the deferred tax liability is not permitted to netthis deferred tax liability against deferred tax assets when determiningregulatory capital limitations on deferred tax assets.  For these financial institutions, the amountof goodwill deducted from tier 1 capital will reflect each institution’smaximum exposure to loss in the event that the entire amount of goodwill isimpaired or derecognized, an event which triggers the concurrent derecognitionof the related deferred tax liability for financial reporting purposes.

 

On October 7, 2008 theFDIC adopted a restoration plan that would increase the rates banks pay fordeposit insurance, and proposed rules for adjusting the system thatdetermines what deposit insurance premium rate a bank pays the FDIC.  Currently, banks pay anywhere from five basispoints to 43 basis points for deposit insurance. Under the proposal rule, theassessment rate schedule would be raised uniformly by 7 basis points(annualized) beginning on January 1, 2009. Beginning with the second quarter of 2009, changes would be made to thedeposit insurance assessment system to make the increase in assessments fairerby requiring riskier institutions to pay a larger share.  Together, the proposed changes would improvethe way the system differentiates risk among insured institutions and helpensure that the reserve ratio returns to at least 1.15 percent by the end of2013.  The proposed changes to theassessment system include assessing higher rates to institutions with asignificant reliance on secured liabilities, which generally raises the FDIC’sloss in the event of failure without providing additional assessmentrevenue.  The proposal also would assesshigher rates for institutions with a significant reliance on brokered depositsbut, for well-managed and well-capitalized institutions, only when accompaniedby rapid asset growth.  Brokered depositscombined with rapid asset growth have played a role in a number of costlyfailures, including some recent ones. The proposal also would provide incentives in the form of a reduction inassessment rates for institutions to hold long-term unsecured debt and, forsmaller institutions, high levels of Tier 1 capital.  The FDIC also voted to maintain theDesignated Reserve Ratio at 1.25 percent as a signal of its long term targetfor the fund.

 

TheFederal Reserve Board in October 2008 approved final amendments toRegulation C that revise the rules for reporting price information onhigher-priced mortgage loans.  The changes are intended to improve theaccuracy and usefulness of data reported under the Home Mortgage DisclosureAct.  Regulation C currently requireslenders to collect and report the spread

 

15

----

Tableof Contents

 

betweenthe annual percentage rate (APR) on a mortgage loan and the yield on a Treasurysecurity of comparable maturity if the spread is greater than 3.0 percentagepoints for a first lien loan or greater than 5.0 percentage points for asubordinate lien loan.  This difference is known as a rate spread.  Under the final rule, a lender will reportthe spread between the loan’s APR and a survey-based estimate of APRs currentlyoffered on prime mortgages of a comparable type (“average prime offer rate”) ifthe spread is equal to or greater than 1.5 percentage points for a first lienloan or equal to or greater than 3.5 percentage points for a subordinate-lienloan.  The Board will publish average prime offer rates based on thePrimary Mortgage Market Survey® currently published by Freddie Mac.  Insetting the rate spread reporting threshold, the Board sought to cover subprimemortgages and generally avoid covering prime mortgages.  The changes toRegulation C conform the threshold for rate spread reporting to the definitionof higher-priced mortgage loans adopted by the Board under Regulation Z (Truthin Lending) in July of 2008.

 

The Federal Reserve Board in July 2008approved a final rule for home mortgage loans to better protect consumersand facilitate responsible lending.  The rule prohibits unfair,abusive or deceptive home mortgage lending practices and restricts certainother mortgage practices.  The final rule also establishesadvertising standards and requires certain mortgage disclosures to be given toconsumers earlier in the transaction.  The final rule, which amendsRegulation Z (Truth in Lending) and was adopted under the Home Ownership andEquity Protection Act, largely follows a proposal released by the Board in December 2007,with enhancements that address ensuing public comments, consumer testing, andfurther analysis.

 

The final rule adds four key protectionsfor a newly defined category of “higher-priced mortgage loans” secured by aconsumer’s principal dwelling.  For loans in this category, theseprotections will:

 

·                  Prohibit alender from making a loan without regard to borrowers’ ability to repay theloan from income and assets other than the home’s value.  A lendercomplies, in part, by assessing repayment ability based on the highestscheduled payment in the first seven years of the loan.  To show that a lender violated thisprohibition, a borrower does not need to demonstrate that it is part of a “patternor practice.”

 

·                  Requirecreditors to verify the income and assets they rely upon to determine repaymentability.

 

·                  Ban anyprepayment penalty if the payment can change in the initial four years. For other higher-priced loans, a prepayment penalty period cannot last for morethan two years.

 

·                  Requirecreditors to establish escrow accounts for property taxes and homeowner’sinsurance for all first-lien mortgage loans.

 

In addition to the rules governinghigher-priced loans, the rules adopt the following protections for loanssecured by a consumer’s principal dwelling, regardless of whether the loan ishigher-priced:

 

·                  Creditors andmortgage brokers are prohibited from coercing a real estate appraiser tomisstate a home’s value.

 

·                  Companies thatservice mortgage loans are prohibited from engaging in certain practices, suchas pyramiding late fees.  In addition, servicers are required to creditconsumers’ loan payments as of the date of receipt and provide a payoffstatement within a reasonable time of request.

 

·                  Creditors mustprovide a good faith estimate of the loan costs, including a schedule ofpayments, within three days after a consumer applies for any mortgage loansecured by a consumer’s principal dwelling, such as a home improvement loan ora loan to refinance an existing loan.  Currently, early cost estimates areonly required for home-purchase loans.  Consumers cannot be charged anyfee until after they receive the early disclosures, except a reasonable fee forobtaining the consumer’s credit history.

 

For all mortgages, the rule also setsadditional advertising standards.  Advertising rules now requireadditional information about rates, monthly payments, and other loanfeatures.  The final rule bans seven deceptive or misleadingadvertising practices, including representing that a rate or payment is “fixed”when it can change.  The rule’sdefinition of “higher-priced mortgage loans” will capture virtually all loansin the subprime market, but generally exclude loans in the prime market. To provide an index, the Federal Reserve Board will publish the “average primeoffer rate,” based on a survey currently published by Freddie Mac.  A loanis higher-priced if it is a first-lien mortgage and has an annual percentagerate that is 1.5 percentage points or more above this index, or 3.5 percentagepoints if it is a subordinate-lien mortgage.  The new rules take effecton October 1, 2009.  The single exception is the escrow requirement,which will be phased in during 2010 to allow lenders toestablish new systems as needed.

 

16

----

Table of Contents

 

InMay 2008, the Federal Reserve Board proposed rules to prohibit unfairpractices regarding credit cards and overdraft services that would, among otherprovisions, protect consumers from unexpected increases in the rate charged onpre-existing credit card balances.  Therules, proposed for public comment under the Federal Trade Commission Act (FTCAct), also would forbid banks from imposing interest charges using the “two-cycle”billing method, would require that consumers receive a reasonable amount oftime to make their credit card payments, and would prohibit the use of paymentallocation methods that unfairly maximize interest charges.  They also include protections for consumersthat use overdraft services offered by their bank.  The proposed changesto the Board’s Regulation AA (Unfair or Deceptive Acts or Practices) would becomplemented by separate proposals that the Board is issuing under the Truth inLending Act (Regulation Z) and the Truth in Savings Act (Regulation DD).

 

Theprovisions addressing credit card practices are part of the Board’s ongoingeffort to enhance protections for consumers who use credit cards, and followthe Board’s 2007 proposal to improve the credit card disclosures under theTruth in Lending Act. The FTC Act proposal includes five key protections forconsumers that use credit cards:

 

·                  Bankswould be prohibited from increasing the rate on a pre-existing credit cardbalance (except under limited circumstances) and must allow the consumer to payoff that balance over a reasonable period of time.

 

·                  Bankswould be prohibited from applying payments in excess of the minimum in a mannerthat maximizes interest charges.

 

·                  Bankswould be required to give consumers the full benefit of discounted promotionalrates on credit cards by applying payments in excess of the minimum to anyhigher-rate balances first, and by providing a grace period for purchases wherethe consumer is otherwise eligible.

 

·                  Bankswould be prohibited from imposing interest charges using the “two-cycle”method, which computes interest on balances on days in billing cycles precedingthe most recent billing cycle.

 

·                  Bankswould be required to provide consumers a reasonable amount of time to makepayments.

 

Theproposal would also address subprime credit cards by limiting the fees thatreduce the available credit.  In addition,banks that make firm offers of credit advertising multiple rates or creditlimits would be required to disclose in the solicitation the factors thatdetermine whether a consumer will qualify for the lowest rate and highestcredit limit.  The Board’s proposal underthe FTC Act also addresses acts or practices in connection with a bank’spayment of overdrafts on a deposit account, whether the overdraft is created bycheck, a withdrawal at an automated teller machine, a debit card purchase, orother transactions.  The proposalrequires institutions to provide consumers with notice and an opportunity toopt out of the payment of overdrafts, before any overdraft fees or charges maybe imposed on consumers’ accounts.

 

InDecember 2007, the FDIC issued a proposed rule to improve the processfor determining uninsured depositors at larger institutions in the event of afailure.  The measure is intended toallow the FDIC to make funds promptly available to insured deposit customers inthe unlikely event that a large financial institution is closed.  The proposal is broken into two parts. Onesection relates to so-called covered institutions, those that have at least $2billion in domestic deposits, have more than 250,000 deposit accounts, or havetotal assets of more than $20 billion, regardless of the number of deposits oraccounts.  A covered institution would berequired to adopt mechanisms that, in the event of a failure, would placeprovisional holds on large deposit accounts in a percentage specified by theFDIC; provide the FDIC with deposit account data in a standard format; andallow automatic removal of provisional holds once the FDIC makes an insurancedetermination.  The second part appliesto all FDIC-insured institutions, regardless of size, and governs the specifictime and circumstance under which account balances will be determined in theevent of a failure.  The FDIC isproposing to use the end-of-day ledger balance as normally calculated by theinstitution.  By using the end-of-dayledger, the FDIC will be able to apply a single standard across all failedbanks in order to treat every transaction equally. This is also the samedeposit balance used for Call Report and assessment purposes.  There would be no requirements placed on openinstitutions as a result of this provision. The FDIC places a high priority on providing access to insured depositspromptly and, in the past, has usually been able to allow most depositorsaccess to their deposits on the next business day.  If adopted, the proposed rule wouldbetter enable the FDIC to continue this practice, especially for the larger,more complex institutions it insures.

 

TheFederal Reserve Board in November 2007 approved final rules toimplement the Basel II framework for large bank capital requirements.  The new risk-based capital requirements applyto large, internationally active banking organizations in the UnitedStates.  The new capital adequacyrequirements were designed to align regulatory capital requirements with actual

 

17

----

Tableof Contents

 

risksand are expected to strengthen banking organizations’ risk-managementpractices.  Basel II would replace thecurrent U.S. rules implementing the Basel Capital Accord of 1988 (Basel I)and be mandatory for large, internationally active banking organizations(so-called “core” banking organizations with at least $250 billion in totalassets or at least $10 billion in foreign exposure) and optional forothers.  Under Basel II, core banking organizations would be required toenhance the measurement and management of their risks, including credit riskand operational risk.  Core bankingorganizations will be required to have rigorous processes for assessing theiroverall capital adequacy in relation to their total risk profile and topublicly disclose information about their risk profile and capital adequacy.

 

Thenew U.S. Basel II rule is technically consistent in most respects withinternational approaches and includes a number of prudential safeguards asoriginally proposed in September 2006.  These safeguards include arequirement that banking organizations satisfactorily complete a four-quarterparallel run period before operating under the Basel II framework, arequirement that an institution satisfactorily complete a series oftransitional periods before operating under Basel II without floors, and acommitment by the agencies to conduct ongoing analysis of the framework to ensureBasel II is working as intended.  BaselII in the United States will be implemented with retention of the leverageratio and prompt corrective action (PCA) requirements, which will continue tobolster capital and complement risk-based measures.  Following a successful parallel run period, abanking organization would have to progress through three transitional periods(each lasting at least one year), during which there would be floors onpotential declines in risk-based capital requirements.  Those transitional floors would limit maximumcumulative reductions of a banking organization’s risk-based capitalrequirements to 5 percent during the first transitional floor period, 10percent during the second transitional floor period, and 15 percent during thethird transitional floor period.  A banking organization would needapproval from its primary federal regulator to move into each of thetransitional floor periods, and at the end of the third transitional floorperiod to move to full Basel II.

 

InSeptember 2007, the SEC and Federal Reserve Board of Governors adoptedfinal rules to implement the bank “broker” provisions of theGramm-Leach-Bliley Act.  The rules definethe scope of securities activities that banks may conduct without registeringwith the SEC as a securities broker and implement the most important “broker”exceptions for banks adopted by the GLB Act.  Specifically, the rules implementthe statutory exceptions that allow a bank, subject to certain conditions, tocontinue to conduct securities transactions for its customers as part of thebank’s trust and fiduciary, custodial and deposit “sweep” functions, and torefer customers to a securities broker-dealer pursuant to a networkingarrangement with the broker-dealer.  The rules are designed to accommodatethe business practices of banks and to protect investors.  The effectivedate for compliance is the first day of the bank’s fiscal year commencing afterSeptember 30, 2008.

 

Thefederal financial regulatory agencies in December 2006 issued an interagencypolicy statement on the allowance for loan and lease losses (ALLL) along withsupplemental frequently asked questions. The policy statement revises and replaces a 1993 policy statement on theALLL.  The agencies issued the revisedpolicy statement in view of today’s uncertain economic environment and thepresence of concentrations in untested loan products in the loan portfolios ofinsured depository institutions.  Thepolicy statement has also been revised to conform with generally acceptedaccounting principles (GAAP) and post-1993 supervisory guidance.  The 1993 policy statement described theresponsibilities of the boards of directors, management, and banking examinersregarding the ALLL; factors to be considered in the estimation of the ALLL; andthe objectives and elements of an effective loan review system, including asound credit grading system.  The policystatement reiterates that each institution has a responsibility for developing,maintaining and documenting a comprehensive, systematic, and consistentlyapplied process appropriate to its size and the nature, scope, and risk of itslending activities for determining the amounts of the ALLL and the provisionfor loan and lease losses and states that each institution should ensurecontrols are in place to consistently determine the ALLL in accordance withGAAP, the institution’s stated policies and procedures, management’s bestjudgment and relevant supervisory guidance.

 

Thepolicy statement also restates that insured depository institutions mustmaintain an ALLL at a level that is appropriate to cover estimated creditlosses on individually evaluated loans determined to be impaired as well asestimated credit losses inherent in the remainder of the loan and leaseportfolio, and that estimates of credit losses should reflect consideration ofall significant factors that affect the collectibility of the portfolio as ofthe evaluation date.  The policystatement states that prudent, conservative, but not excessive, loan lossallowances that represent management’s best estimate from within an acceptablerange of estimated losses are appropriate.

 

TheOffice of the Comptroller of the Currency, the Board of Governors of theFederal Reserve System, and the Federal Deposit Insurance Corporation in December 2006issued final guidance on sound risk management practices for concentrations incommercial real estate lending.  Theagencies observed that the commercial real estate is an area in which somebanks are becoming increasingly concentrated, especially with small- to medium-sized banks that face strong competition in their other business lines.  The agencies support banks serving a vitalrole in their communities by supplying credit for business and real estate development.  However, the agencies are concerned thatrising commercial real estate loan

 

18

----

Tableof Contents

 

concentrationsmay expose institutions to unanticipated earnings and capital volatility in theevent of adverse changes in commercial real estate markets.  The guidance provides supervisory criteria,including numerical indicators to assist in identifying institutions with potentiallysignificant commercial real estate loan concentrations that may warrant greatersupervisory scrutiny, but such criteria are not limits on commercial realestate lending.

 

CaliforniaAssembly Bill 1301 was signed by Gov. Schwarzenegger on July 16, 2008 andbecame law on January 1, 2009.  Among other things, the bill eliminatedunnecessary applications that consume time and resources of bank licensees andwhich in many cases are now perfunctory. All of current Article 5 – “Locations of Head Office” of Chapter 3,and all of Chapter 4 – “Branch Offices, Other Places of Business and AutomatedTeller Machines” were repealed.  A newChapter 4 – “Bank Offices” was added. The new Chapter 4 requires notice to the California Department ofFinancial Institutions (“CDFI”) the establishment of offices, rather than thecurrent application process.  Many of thecurrent branch applications are perfunctory in nature and/or provide for awaiver of application.  Banks, on anexception basis, may be subject to more stringent requirements as deemednecessary.  As an example, new banks,banks undergoing a change in ownership and banks in less than satisfactorycondition may be required to obtain prior approval from the CDFI beforeestablishing offices if such activity is deemed to create an issue of safetyand soundness.  The bill eliminatedunnecessary provisions in the Banking Law that are either outdated or havebecome undue restrictions to bank licensees. Chapter 6 – “Powers and Miscellaneous Provisions” was repealed.  A new Chapter 6 - “Restrictions and ProhibitedPractices” was added.  This chapterbrings together restrictions in bank activities as formerly found in Chapter 18– “Prohibited Practices and Penalties.” However, in bringing the restrictions into the new chapter, variousprovisions were updated to remove the need for prior approval by the DFICommissioner.  The bill renumberedcurrent Banking Law sections to align like sections.  Chapter 4.5 – “Authorizations for Banks” wasadded. The purpose of the chapter is to provide exceptions to certain activitiesthat would otherwise be prohibited by other laws outside of the FinancialCode.  The bill added Article 1.5 - “Loanand Investment Limitations” to Chapter 10 – “Commercial Banks.”  This article is new in concept andacknowledges that investment decisions are business decisions – so long asthere is a diversification of the investments to spread any risk.  The risk is diversified in this article byplacing a limitation on the loans and investments that can be made to any oneentity.  This section is a trade-off forelimination of applications to the DFI for approval of investments insecurities, which were repealed.

 

Otherchanges AB 1301 made to the Banking Law:

 

·                  Authorizeda bank or trust acting in any capacity under a court or private trust toarrange for the deposit of securities in a securities depository or federalreserve bank, and provided how they may be held by the securities depository;

 

·                  Reducedfrom 5% to 1% the amount of eligible assets to be maintained at an approveddepository by an office of a foreign (other nation) bank for the protection ofthe interests of creditors of the bank’s business in this state or for theprotection of the public interest;

 

·                  Enabledthe CDFI to issue an order against a bank licensee parent or subsidiary;

 

·                  Providedthat the examinations may be conducted in alternate examination periods if theCDFI concludes that an examination of the state bank by the appropriate federalregulator carries out the purpose of this section, but the CDFI may not accepttwo consecutive examination reports made by federal regulators;

 

·                  Providedthat the CDFI may examine subsidiaries of every California state bank, statetrust company, and foreign (other nation) bank to the extent and whenever andas often as the CDFI shall deem advisable;

 

·                  Enabledthe CDFI issue an order or a final order to now include any bank holdingcompany or subsidiary of the bank, trust company, or foreign banking corporationthat is violating or failing to comply with any applicable law, or isconducting activities in an unsafe or injurious manner;

 

·                  Enabledthe CDFI to take action against a person who has engaged in or participated inany unsafe or unsound act with regard to a bank, including a former employeewho has left the bank.

 

In2007 California, a new Section 691.1 was added to the Financial Code thatexempts a bank from obtaining a securities permit for the followingtransactions:

 

·                  anyoffer (but not a sale) not involving a public offering by a bank organizedunder the laws of this state of its securities

 

19

----

Tableof Contents

 

·                  theexecution and delivery of any agreement for the sale of the securities pursuantto the offer if no part of the consideration for the securities is paid to orreceived by the bank and none of the securities are issued until the sale ofthe securities is authorized by the commissioner or exempted fromauthorization.

 

·                  anystock split by a bank organized under the laws of this state that is effectedpursuant to an amendment to its articles, an agreement of merger, or acertificate of ownership that has been approved by the commissioner, unlessthis exemption is withheld by order of the commissioner

 

·                  anyoffer or sale of securities by a bank organized under the laws of this statethat is either (1) to a person actually approved by the commissionerpursuant to Section 702 of the Financial Code to acquire control of thebank if all of the material terms and conditions of the offer and sale ofsecurities are disclosed in the application for approval specified in Section 702and the offer and sale of securities is in accordance with the terms andsubject to the conditions of the approval to acquire control or (2) in atransaction exempted from the approval requirement of Section 701 by aregulation or an order of the commissioner, unless this exemption is withheldby order of the commissioner.

 

InCalifornia, effective January 1, 2007, a new law Financial Code Section 854.1recognizes the ability of mortgage brokers to obtain the benefit of noninterest-bearing accounts on trust funds deposited in a “commercial bank.”  The provision applies to real estate brokerswho collect payments or provide services in connection with a loan secured by alien on real property and permits a mortgage broker to earn interest on aninterest-bearing account at a financial institution.  Interest on funds received by a real estatebroker who collects payments or provides services for an “institutionalinvestor” in connection with a loan secured by commercial real property mayinure to the broker, if agreed to in writing by the broker and theinstitutional investor.  For purposes ofthis law, commercial real property means real estate improved with other than aone-to-four family residence.

 

A2007 California law makes it easier for California banks to accept depositsfrom local government agencies.  Underthe old law, local agency deposits over $100,000 had to be secured bycollateral.  Pursuant to the enactment ofAssembly Bill 2011, banks would be able to acquire surplus public depositsexceeding $100,000 without pledging collateral if they participate in a depositplacement service where excess amounts are placed in certificates of deposit atother institutions within a network. Such a network (of which currently there is only one available in the market)permits the entire amount of a customer’s deposit to be FDIC-insured, and thebank taking the original deposit retains the benefit of the full amount of thedeposit for lending or other purposes. AB 2011 clarifies that a local agency may deposit up to 30% of itssurplus funds in certificates of deposit at a bank, savings association,savings bank, or credit union that participates in such a deposit-sharingnetwork.  Since the entire amount of thedeposits would be FDIC-insured, a bank would not be required to pledgecollateral.  The bill permits agencies tomake these deposits until January 1, 2012.

 

Itis impossible to predict what effect the enactment of certain of theabove-mentioned legislation will have on the Company.  Moreover, it islikely that other bills affecting the business of banks may be introduced inthe future by the United States Congress or California legislature.

 

**Recent Accounting Pronouncements**

 

*Accounting for Business Combinations*

 

In December 2007, the FASB issued Statement of FinancialAccounting Standards No. 141 (revised 2007), *Business Combinations*(“SFAS No. 141R”).  SFAS No. 141(R), among other things,establishes principles and requirements for how the acquirer in a businesscombination (i) recognizes and measures in its financial statements theidentifiable assets acquired, the liabilities assumed, and any noncontrollinginterest in the acquired business, (ii) recognizes and measures thegoodwill acquired in the business combination or a gain from a bargainpurchase, and (iii) determines what information to disclose to enableusers of the financial statements to evaluate the nature and financial effectsof the business combination.  The Companyis required to adopt SFAS No. 141(R) for all business combinationsfor which the acquisition date is on or after January 1, 2009.  Earlier adoption is prohibited.  This standard will change the accountingtreatment for business combinations on a prospective basis.

 

20

----

Table of Contents

 

*TheHierarchy of Generally Accepted Accounting Principles*

 

In May 2008, the FASB issued SFAS No. 162, *The Hierarchy of Generally Accepted Accounting Principles*(SFASNo. 162). This standard identifies the sources of accounting principles and theframework for selecting the principles to be used in the preparation offinancial statements of nongovernmental entities that are presented inconformity with accounting principles generally accepted in the United Statesof America (GAAP). It establishes that the GAAP hierarchy should be directed toentities because it is the entity (not the auditor) that is responsible forselecting accounting principles for financial statements that are presented inconformity with GAAP. SFAS 162 was effective November 15, 2008.  The adoption of this Statement did not haveany effect on the Company’s consolidated financial statements.

 

**Item 1a. Risk Factors**

 

This discussion and analysisprovides insight into Management’s assessment of the operating trends over thelast several years and its expectations for 2009. Such expressions ofexpectations are not historical in nature and are “forward-looking statements”within the meaning of the Private Securities Litigation Reform Act of 1995.Forward-looking statements are subject to risks and uncertainties that maycause actual future results to differ materially from those expressed in anyforward-looking statement. Such risks and uncertainties with respect to theCompany include:

 

·                  increasedcompetitive pressure among financial services companies;

 

·                  changesin the interest rate environment reducing interest margins or increasinginterest rate risk;

 

·                  continueddeterioration in general economic conditions, internationally, nationally or inthe State of California;

 

·                  theoccurrence of future events such as the terrorist acts of September 11, 2001;

 

·                  theavailability of sources of liquidity at a reasonable cost;

 

·                  the ability to maintain historicalgrowth rates; and

 

·                  legislativeor regulatory changes adversely affecting the business in which the Companyengages.

 

**Competition**

 

The Company faces competitionfrom other financial institutions and from businesses in other industries thathave developed financial products. Banks once had an almost exclusive franchisefor deposit products and provided the majority of business financing. Withderegulation other kinds of financial institutions began to offer competingproducts. Also, increased competition in consumer financial products has comefrom companies not typically associated with the banking and financial servicesindustry, such as AT&T, General Motors and various software developers.Similar competition is faced for commercial financial products from insurancecompanies and investment bankers. Community banks, including the Company,attempt to offset this trend by developing new products that capitalize on theservice quality that a local institution can offer. Among these are new loan,deposit, and investment products. The Company’s primary competitors aredifferent for each specific product and market area. While this offers specialchallenges for the marketing of our products, it offers protection from onecompetitor dominating the Company in its market areas. Many of thesecompetitors are much larger in total assets and capitalization, have greateraccess to capital markets and offer a broader array of financial services thanwe do, which creates certain competitive disadvantages for the Company.

 

**Changes inEconomic Conditions**

 

Changes in economic conditionscould materially affect the Company.  Ourbusiness is directly affected by changes in economic conditions, includingfinance, legislative and regulatory changes and changes in government monetaryand fiscal policies and inflation, all of which are beyond our control.  Continued deterioration in economicconditions could result in the following consequences.

 

·                  Problemassets and foreclosures may increase

 

·                  Demandfor our products and services may decline

 

21

----

Tableof Contents

 

·                  Lowcost or non-interest bearing deposits may decrease

 

·                  Collateralfor loans, especially real estate, may decline in value, reducing the value ofassets and collateral associated with our existing loans.

 

In view of the concentration ofour operations and the collateral securing our loan portfolio, we may beparticularly susceptible to the adverse economic conditions in the state ofCalifornia and in the seven counties where our business is concentrated and tocontinuing adverse changes in the real estate markets we serve.

 

Beginning in the summer of 2004and through 2006 the Federal Reserve Board raised its target rate and by theend of 2006 it had increased by 4.25% to 8.25%. In 2007 the rate was unchanged until September 18, when it was loweredby 25 basis points.  Subsequentadjustments to lower the rate further were done in October and December of 2007with a year end rate of 7.25%.  Then in Januaryof 2008, at an unscheduled meeting, the Federal Reserve Board lowered thetarget rate by 75 basis points to 6.50% and again by 50 basis points on January30, 2008 to 6.0%.  The rate was loweredfive more times during 2008 and ended the year with a 75 basis point drop on December16, 2008 to fix the rate at 3.25%.  Theseactions by the Federal Reserve Board were brought on by conditions of slowingeconomic growth reflecting the intensification of the housing correction anddeclines in business and consumer spending. These changes impacted the Company as market rates for loans,investments and deposits respond to the Federal Reserve Board’s actions. Asignificant portion of our total loan portfolio is related to real estateobligations, particularly residential real estate loans.

 

Dramatic negative developmentsin the latter half of 2007 and throughout 2008 in the subprime mortgage marketand the securitization markets for such loans have resulted in uncertainty inthe financial markets resultant downturn in 2008 and the expectation of acontinuing global economic downturn in 2009. Commercial as well as consumerloan portfolio performances have deteriorated at many institutions and thecompetition for deposits and quality loans has increased significantly. Thevalues of real estate collateral supporting many commercial loans and homemortgages have declined and may continue. Bank and bank holding company stockprices have been negatively affected as has the ability of banks and bankholding companies to raise capital or borrow in the debt markets compared torecent years. There is potential for additional federal or state laws andregulations regarding lending and funding practices and liquidity standards,and bank regulatory agencies are expected to be very aggressive in respondingto concerns and trends identified in examinations, including the expectedissuance of many formal enforcement orders. The Company cannot predict whetheror when potential legislation will be enacted, and if enacted, the effect thatit, or any implementing regulations and supervisory policies, would have on ourfinancial condition or results of operations. In addition, the outcome ofexaminations, any litigation or any investigations initiated by state orfederal authorities may result in necessary changes in our operations andincreased compliance costs.

 

In addition, the instability of the markets and weakness of the economycould affect the strength of the Company’s customers or counterparties, theirwillingness to do business, and/or their ability to fulfill their obligations,which could further affect the Company’s earnings as loans are placed onnon-accrual status. Further, under these circumstances, an additional provisionfor loan and lease losses or unfunded commitments may be required. Currentconditions, including increasing unemployment, deteriorating corporateperformance, the continued softening of real estate markets and the decline ofhome sales and property values, could negatively affect the volume of loanoriginations and prepayments, the value of the real estate securing the Company’smortgage loans, and borrowers’ ability to repay loan obligations, all of whichcould adversely impact the Company’s earnings and financial condition.

 

The continued economic downturn could also affect the market value ofinvestment securities if it is determined that an investment is other thantemporarily impaired. The length of time and extent to which the market valuehas been less than cost; the financial condition of the issuer of the securityand its ability to recover market value; and the Corporation’s intent andability to hold the security to recovery are factors in this determination.

 

**RiskManagement**

 

The Company sees the process ofaddressing the potential impacts of the external factors listed above as partof its management of risk. In addition to common business risks such asdisasters, theft, and loss of market share, the Company is subject to specialtypes of risk due to the nature of its business. New and sophisticatedfinancial products are continually appearing with different types of risk whichneed to be defined and managed if the Company chooses to offer them to itscustomers. Also, the risks associated with existing products must be reassessedperiodically. The Company cannot operate risk-free and make a profit. Instead,the process of risk definition and assessment allows the Company to select theappropriate level of risk for the anticipated level of reward and then decideon the steps necessary to manage this risk. The Company’s Risk Officer and theother members of its Senior Management Team under the direction and oversightof the Board of Directors lead the risk management process.

 

22

----

Table of Contents

 

Some of the risks faced by theCompany are those faced by most enterprises — reputational risk, operationalrisk, and legal risk. The special risks related to financial products are **credit risk** and **interest rate risk.**Creditrisk relates to the possibility that a debtor will not repay according to theterms of the debt contract. Credit risk is discussed in the sections related toloans. Interest rate risk is discussed in the sections related to Liquidity andMarket Risk Management and relates to the adverse impacts of changes ininterest rates. The effective management of these and other risks mentionedabove is the backbone of the Company’s business strategy.

 

**ManagingOur Growth**

 

Our Company’s total assetsincreased from $581 million at December 31, 2007 to $595 million at December 31,2008. Management’s intention is to leverage the Company’s currentinfrastructure and by acquiring the lowest cost deposits available andallocating those deposits into the highest earning assets available,considering the related risk factors. Although no assurance can be providedthat this strategy will result in significant growth. Our ability to managegrowth will depend primarily on our ability to:

 

·                  monitoroperations;

 

·                  control fundingcosts and operating expenses;

 

·                  maintainpositive customer relations; and

 

·                  attract,assimilate and retain qualified personnel.

 

**The Impactof Changes in Assets and Liabilities to Net Interest Income and Net InterestMargin**

 

The Company earns income fromtwo sources. The primary source is from the management of its financial assetsand liabilities and the second is from charging fees for services provided. Thefirst source involves functioning as a **financial intermediary**,that is, the Company accepts funds from depositors or obtains funds from othercreditors and then either lends the funds to borrowers or invests those fundsin securities or other financial instruments. Income is earned as a spreadbetween the interest earned from the loans or investments and the interest paidon the deposits and other borrowings. The second source, fee income, isdiscussed in other sections of this analysis, specifically in “NoninterestRevenue.”

 

**Changes inNet Interest Income and Net Interest Margin**

 

**Netinterest income** is the difference or spread betweenthe interest and fees earned on loans and investments (the Company’s **earning assets**) and the interest expense paid on depositsand other liabilities. The amount by which interest income will exceed interestexpense depends on two factors: (1) the volume or balance of earning assetscompared to the volume or balance of interest-bearing deposits and liabilities,and (2) the interest rate earned on those interest earning assets compared withthe interest rate paid on those interest-bearing deposits and liabilities.

 

**Netinterest margin**is net interest income expressed as apercentage of average earning assets. It is used to measure the differencebetween the average rate of interest earned on assets and the average rate ofinterest that must be paid on liabilities used to fund those assets. Tomaintain its net interest margin, the Company must manage the relationshipbetween interest earned and paid. A shift in the relative size of the majorbalance sheet categories has an impact on net interest income and net interestmargin. To the extent that funds invested in securities can be repositionedinto loans, earnings increase because of the higher rates paid on loans.However, additional credit risk is incurred with loans compared to the very lowrisk of loss on securities, and the Company must carefully monitor theunderwriting process to ensure that the benefit of the additional interestearned is not offset by additional credit losses. In general, depositors arewilling to accept a lower rate on their funds than are other providers of fundsbecause of the Federal Deposit Insurance Corporation (“FDIC”) insurancecoverage. To the extent that the Company can fund asset growth by deposits, especiallythe lower cost transaction accounts, rather than borrowing funds from otherfinancial institutions, the average rates paid on funds will be less, and netinterest income more.

 

**TheAllowance for Loan Losses May Not Cover Actual Loan Losses.**We attempt to limit the risk that borrowers will fail to repay loans bycarefully underwriting the loans, nevertheless losses can and do occur. Wecreate an allowance for loan losses in our accounting records, based onestimates of the following:

 

·                  industrystandards;

 

·                  historicalexperience with our loans;

 

·                  evaluationof qualitative factors such as loan concentrations and local economicconditions;

 

23

----

Table of Contents

 

·                  regularreviews of the quality, mix and size of the overall loan portfolio;

 

·                  regularreviews of delinquencies; and

 

·                  thequality of the collateral underlying our loans;

 

·                  loanimpairment.

 

We maintain an allowance forloan losses at a level which we believe is adequate to absorb any specificallyidentified losses as well as any other losses inherent in our loan portfolio.However, changes in economic, operating and other conditions, including changesin interest rates, which are beyond our control, may cause our actual loanlosses to exceed our current allowance estimates. If the actual loan lossesexceed the amount reserved, it will hurt our business. In addition, the FDICand the California Department of Financial Institutions, as part of theirsupervisory functions, periodically review our allowance for loan losses. Suchagencies may require us to increase our provision for loan losses or torecognize further loan losses, based on their judgments, which may be differentfrom those of our management. Any increase in the allowance required by theFDIC or the California Department of Financial Institutions could also impactour business.

 

The slowdown in the housing industry in 2008, which has affected ourconstruction and development portfolio, has led to an increase of foreclosuresinto other real estate on residential and development related properties.Declines in the market values of these properties after foreclosure haveresulted in additional losses by valuation adjustments which have lead toincreased net charge-offs and increases in the allowance for loan and leaselosses, this could have a material adverse effect on our business, financialcondition and results of operations and prospects.

 

**Item 1b. Unresolved Staff Comments**

 

No comments have been submittedto the registrant by the staff of the Securities Exchange Commission.

 

**Item 2.****           Properties**

 

The following properties (realproperties and/or improvements thereon) are owned by the Company and areunencumbered. In the opinion of Management, all properties are adequatelycovered by insurance.

 
| **Location**                                                                                                                             | ** ** | **Use of Facilities** | ** ** | **Square Feet of  Office Space** | ** ** | **Land and  Building Cost** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|----------------------------------|------------|-----------------------------|------------|
|                                                                                                                                     |       |                  |       |                             |       |                        |       |
| 237 West  East Avenue  Chico, California  (Branch opened June 1999, moved to this site November 2003)  building is owned, land is leased |       | Branch  Office        |       | 4,771                            |       | $                           | 845,493    |   |
|                                                                                                                                     |       |                  |       |                             |       |                        |       |
| 1335 Hilltop  Dr  Redding, California  (Branch opened August 2007)                                                                       |       | Branch  Office        |       | 4,150                            |       | $                           | 1,447,000  |   |
|                                                                                                                                     |       |                  |       |                             |       |                        |       |
| 5026 Rhonda  Rd  Anderson, California  (Opened August 2007)                                                                              |       | Branch  Office        |       | 3,202                            |       | $                           | 1,012,000  |   |

 

24

----

Table of Contents

 

The following facilities areleased by the Company:

 
| ** **                                                             | ** ** | ** **                          | ** ** | **Square Feet of** | ** ** | **Monthly Rent**    | ** ** | **Term of** | ** **     |
|------------------------------------------------------------------------|------------|-------------------------------------|------------|--------------------|------------|---------------------|------------|-------------|----------------|
| **Location**                                                           | ** ** | **Use of  Facilities**              | ** ** | **Office  Space**  | ** ** | **as of  12/31/08** | ** ** | **Lease**   | ** **     |
|                                                                   |       |                                |       |               |       |                |       |        |           |
| 14001  Lakeridge Circle  Magalia, California                           |       | Branch  Office                      |       | 600                |       | $                   | 570        |        | 3/31/2013      | (1) |
|                                                                   |       |                                |       |               |       |                |       |        |           |
| 237 West  East Ave.  Chico, California  land lease only                |       | Branch  Office                      |       |               |       | $                   | 4,552      |        | 10/31/2028     | (2) |
|                                                                   |       |                                |       |               |       |                |       |        |           |
| 900 Mangrove  Ave.  Chico, California                                  |       | Branch  Office                      |       | 6,000              |       | $                   | 7,132      |        | 9/30/2011      | (3) |
|                                                                   |       |                                |       |               |       |                |       |        |           |
| 6653 Clark  Road  Paradise, California                                 |       | Branch  Office                      |       | 4,640              |       | $                   | 5,405      |        | 3/31/2013      | (4) |
|                                                                   |       |                                |       |               |       |                |       |        |           |
| 2951 Churn  Creek Rd  Redding, California                              |       | Branch  Office                      |       | 15,000             |       | $                   | 9,951      |        | 6/30/2011      | (5) |
|                                                                   |       |                                |       |               |       |                |       |        |           |
| 5959  Greenback #430  Citrus Heights, California                       |       | Loan Office                         |       | 1,315              |       | $                   | 3,223      |        | 7/31/2012      | (6) |
|                                                                   |       |                                |       |               |       |                |       |        |           |
| 936 Mangrove  Ave.  Chico, California                                  |       | General  Offices                    |       | 6,000              |       | $                   | 4,786      |        | 2/28/2013      | (7) |
|                                                                   |       |                                |       |               |       |                |       |        |           |
| 904 B Street  Marysville CA                                            |       | Branch  office                      |       | 4,742              |       | $                   | 10,670     |        | 10/31/2016     | (8) |
|                                                                   |       |                                |       |               |       |                |       |        |           |
| 1017 Bridge  St  Colusa CA                                             |       | Branch  office                      |       | 1,500              |       | $                   | 1,300      |        | 2/28/2014      | (9) |
|                                                                   |       |                                |       |               |       |                |       |        |           |
| 1010 Spruce  Street  Gridley CA                                        |       | Loan Office                         |       | 960                |       | $                   | 1,000      |        | month to month |   |
|                                                                   |       |                                |       |               |       |                |       |        |           |
| 950 Hwy 99W  Corning CA                                                |       | Branch  office                      |       | 5,300              |       | $                   | 13,250     |        | 10/31/2026     | (10) |
|                                                                   |       |                                |       |               |       |                |       |        |           |
| 1335 Hilltop  Dr  Redding CA  land lease only                          |       | Branch  office                      |       |               |       | $                   | 6,250      |        | 2/28/2021      | (11) |
|                                                                   |       |                                |       |               |       |                |       |        |           |
| 5026 Rhonda  Rd  Anderson, CA  land lease only                         |       | Branch  Office                      |       |               |       | $                   | 4,500      |        | 12/31/2027     | (12) |
|                                                                   |       |                                |       |               |       |                |       |        |           |
| 672 Pearson  Road  Paradise, California  (Opened December 1990)        |       | Branch  Office                      |       | 4,200              |       | $                   | 9,873      |        | 2/28/2023      | (13) |
|                                                                   |       |                                |       |               |       |                |       |        |           |
| 2227 Myers  Street  Oroville, California  (Opened December 1990)       |       | Branch  Office                      |       | 9,800              |       | $                   | 7,553      |        | 2/28/2023      | (14) |
|                                                                   |       |                                |       |               |       |                |       |        |           |
| 2041 Forest  Avenue  Chico, California  (Opened September 1996)        |       | Branch  Office                      |       | 8,000              |       | $                   | 19,273     |        | 2/28/2023      | (15) |
|                                                                   |       |                                |       |               |       |                |       |        |           |
| 1390  Ridgewood Drive  Chico California  (Opened May 1998)             |       | Central  Services/ Information Svcs |       | 8,432              |       | $                   | 7,044      |        | 2/28/2023      | (16) |
|                                                                   |       |                                |       |               |       |                |       |        |           |
| 1600 Butte  House Road  Yuba City, California  (Opened September 1997) |       | Branch  Office                      |       | 6,580              |       | $                   | 20,361     |        | 2/28/2023      | (17) |
|                                                                   |       |                                |       |               |       |                |       |        |           |
| 10 Gilmore  Road  Red Bluff, California  (Branch opened May 2004,      |       | Branch  Office                      |       | 8,000              |       | $                   | 16,398     |        | 2/28/2023      | (18) |
|                                                                   |       |                                |       |               |       |                |       |        |           |
| 1360 East  Lassen Avenue  Chico, California  (occupancy January 2007)  |       | Administration  Credit Services     |       | 17,000             |       | $                   | 17,799     |        | 2/28/2023      | (19) |

 

----

(1)  This is the termination dateof the current 5-year lease.  The Companyalso has one renewal option for five years.

(2)  This is the termination dateof the current 25-year lease.  TheCompany also has three renewal options for five years each

(3)  This is the termination dateof the current 10-year lease.  TheCompany also has three renewal options for five years each.

(4)  This is the termination dateof the current 10-year lease.  TheCompany also has two renewal options for five years each.

(5)  This is the termination dateof the current 10-year lease.  TheCompany has two renewal options for five years each.

(6)  This is the termination dateof the current 5-year lease. The Company does not have renewal options on thisproperty.

(7)  This is the termination dateof the current 10-year lease.  TheCompany also has one renewal option for ten years.

(8)  This is the termination dateof the current 10-year lease.  TheCompany has two renewal options for five years each.

(9) This is the termination date of the current 10-year lease.  The Company does not have renewal options onthis property.

(10) This is the termination date of the current 20 year lease.  The Company does not have renewal options onthis property.

(11) This is the termination date of the current 15 year landlease.  The Company has three renewaloptions for five years each.

(12) This is the termination date of the current 15 year lease.  The Company has three renewal options forfive years each.

(13) This is the termination date of the current 15 year lease.  The Company has two renewal options for tenyears each.

(14) This is the termination date of the current 15 year lease.  The Company has two renewal options for tenyears each.

(15) This is the termination date of the current 15 year lease.  The Company has two renewal options for tenyears each.

(16) This is the termination date of the current 15 year lease.  The Company has two renewal options for tenyears each.

(17) This is the termination date of the current 15 year lease.  The Company has two renewal options for tenyears each.

(18) This is the termination date of the current 15 year lease.  The Company has two renewal options for tenyears each.

(19) This is the termination date of the current 15 year lease.  The Company has two renewal options for tenyears each.

 

25

----

Table of Contents

 

**Item 3.****           LegalProceedings**

 

From time to time, the Companyis a party to claims and legal proceedings arising in the ordinary course ofbusiness. After taking into consideration information furnished by counsel tothe Company as to the current status of these claims or proceedings to whichthe Company is a party, management is of the opinion that the ultimateaggregate liability represented thereby, if any, will not have a materialadverse affect on the financial condition of the Company.

 

**Item 4.****           Submissionof Matters to a Vote of Security Holders**

 

No matters were submitted to avote of our shareholders’ during the fourth quarter of the fiscal year ended December31, 2008.

 

**PART II**

 

**Item 5.****           Marketfor Registrants Common Equity and Related Shareholder Matters and IssuerPurchases of Equity Securities**

 

**(a)****                                  MarketInformation**

 

Community Valley Bancorp waspreviously listed on the Nasdaq OTC Bulletin Board starting June 17, 2002 (theeffective date of the holding company reorganization), and Butte Community Bankwas previously also listed on the Nasdaq OTC Bulletin Board. Our Common Stocktrades under the symbol CVLL and the CUSIP number for such common stock is#20415P101. Previously the Butte Community Bank CUSIP number for the commonstock was #12406Q107.  On May 1, 2006 theCompany began trading on the Nasdaq Capital Market.   Trading in the Company has not beenextensive and such trades cannot be characterized as amounting to an activetrading market. Management is aware of the following securities dealers whomake a market in the Company’s stock: Howe Barnes Hoefer & Arnett Inc., SanFrancisco, California, Wachovia First Union Securities, Grass Valley,California, Wedbush Morgan Securities, Lake Oswego, Oregon and Sandler O’Neill &Partners, LP, New York, NY, (the “Securities Dealers”).

 

The graph that follows showsthe total return performance of the Company as compared to the Russell 3000 andthe SNL $100 million to $500 million peer group of banks over the past fiveyears.

 

***CommunityValleyBancorp***

 

 

26

----

Table of Contents

 

The following table summarizestrades of the Company setting forth the approximate high and low sales pricesand volume of trading for the periods indicated, based upon informationprovided by public sources. The information in the following table does notinclude trading activity between dealers.

 
| ** **         | ** ** | **Sale Price  of the Company’s** | ** ** | **Approximate**    | ** ** |
|--------------------|------------|---------------------------------------|------------|--------------------|------------|
| **Calendar**       | ** ** | **Common Stock**                      | ** ** | **Trading Volume** | ** ** |
| **Quarter Ended**  | ** ** | **High**                              | ** ** | **Low**            | ** ** | **Shares** | ** ** |
| March 31, 2007     |       | 15.00                                 |       | 12.00              |       | 130,814 |   |
| June 30, 2007      |       | 14.00                                 |       | 12.24              |       | 94,267 |   |
| September 30, 2007 |       | 14.59                                 |       | 10.02              |       | 131,088 |   |
| December 31, 2007  |       | 13.85                                 |       | 9.45               |       | 140,544 |   |
| March 31, 2008     |       | 12.50                                 |       | 9.20               |       | 193,391 |   |
| June 30, 2008      |       | 12.35                                 |       | 6.75               |       | 95,659 |   |
| September 30, 2008 |       | 9.39                                  |       | 6.00               |       | 69,789 |   |
| December 31, 2008  |       | 7.50                                  |       | 4.14               |       | 72,247 |   |

######  

###### **(b)****                                  Holders**

######  

###### On March 27, 2009 there were approximately 540 shareholders of recordof the Company.

######  

**(c)**                                  **Dividends**

 

As a financial holding companywhich currently has no significant assets other than its equity interest in theBank and the proceeds from the issuance of the Trust Preferred Securitiespreviously mentioned, the Company’s ability to declare dividends dependsprimarily upon dividends it receives from the Bank. The Bank’s dividendpractices in turn depend upon the Bank’s earnings, financial position, currentand anticipated cash requirements and other factors deemed relevant by the Bank’sBoard of Directors at that time.

 

The policy is to declare andpay dividends of no more than 40% of its previous year’s net income toshareholders. However, no assurance can be given that the Bank’s and theCompany’s future earnings and/or growth expectations in any given year willjustify the payment of such a dividend.

 

The Company paid cash dividendsduring the first three quarters of 2008 before suspending the dividend paymentin the fourth quarter.  A total of $1.1million or $0.16 per share was paid in 2008 compared to $2.4 million or $0.32per share in 2007, representing 18% and 37%, respectively of the prior year’searnings.   The Company suspended itspayment of dividends to shareholders in the fourth quarter of 2008 to preserveits capital as it became apparent economic conditions would not support thepayment of dividends and the maintenance of minimum capital ratios establishedby the Company.

 

The ability of the Bank’s Boardof Directors to declare cash dividends is also limited by statutory andregulatory restrictions which restrict the amount available for cash dividendsdepending upon the earnings, financial condition and cash needs of the Bank, aswell as general business conditions. A detailed discussion is located in Item 1above.

 

**(d)****                                  StockRepurchase Plan**

 

In March 2008, Community ValleyBancorp announced an offer to purchase up to 1,000,000 shares of its commonstock at a purchase price of $13.00. Based on the final count by the depositary for the tender offer,shareholders properly tendered 1,572,907 shares of its common stock.  The Board of Directors of Community ValleyBancorp elected to not exercise its oversubscription privileges in the tenderoffer to purchase more than 1,000,000 properly tendered shares and purchased atotal of 999,939 shares at $13.00 per share representing a pro-rata share ofthe tendered shares of 63.38%, on May 5, 2008.

 

The Board of Directors approveda plan to repurchase up to $6,000,000 of the outstanding common stock of theCompany in 2007. Stock repurchases were made from time to time on the openmarket or through privately negotiated transactions. The timing of purchasesand the exact number of shares purchased was dependent on market conditions.The share repurchase program did not include specific price targets ortimetables and could have been suspended at any time. During 2008, 12,067shares were repurchased for $119,000 at an average price of $9.84 per share.

 

The Board of Directors approved a plan torepurchase up to $3,000,000 of the outstanding common stock of the Company in2003. Stock repurchases were made from time to time on the open market orthrough privately negotiated transactions. The timing of purchases and theexact number of shares purchased was dependent on market conditions. The sharerepurchase program did not include specific price targets or timetables andcould have been suspended at any time. During 2006, 143,950 shares wererepurchased for $2,498,000 at an average price of $17.35 per share. During2005, no shares of the Company’s common stock were repurchased. There were noshares available for repurchase under this plan after December 31, 2006.

 

27

----

Table of Contents

 

**(e)****                                 ****Equity Compensation PlanInformation**

 

Thefollowing chart sets forth information for the fiscal year ended December 31,2008, regarding equity based compensation plans of the Company.

 
| ** **                                                  | ** ** | **Number of securities  to be issued upon  exercise of  outstanding options,  warrants, and rights** | ** ** | **Weighted  average exercise  price of  outstanding  options, warrants  and rights** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation plans  (excluding securities  reflected in column (a).** | ** ** |
|-------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| **Plan Category**                                           | ** ** | **(a)**                                                                                              | ** ** | **(b)**                                                                              | ** ** | **(c)**                                                                                                                                              | ** ** |
| Equity compensation plans approved by  security holders     |       | 350,231                                                                                              |       | $                                                                                    | 8.30       |                                                                                                                                                 | 96,916     |   |
|                                                        |       |                                                                                                 |       |                                                                                 |       |                                                                                                                                                 |       |
| Equity compensation plans not approved by  security holders |       | None                                                                                                 |       | None                                                                                 |       | None                                                                                                                                                 |       |
|                                                        |       |                                                                                                 |       |                                                                                 |       |                                                                                                                                                 |       |
| Total                                                       |       | 350,231                                                                                              |       | $                                                                                    | 8.30       |                                                                                                                                                 | 96,916     |   |

 

**(f)****                                    Salesof Unregistered Securities**

 

On July 10, 2007 the Companyissued an aggregate of $8,000,000 in principal amount of its Fixed Rate MiddleMarket Capital Securities due 2037 (the “Subordinated Debt Securities”). All ofthe Subordinated Debt Securities were issued to Community Valley Trust II, aDelaware statutory business trust and a wholly-owned but unconsolidatedsubsidiary of the Company (the “Trust”). The Subordinated Debt Securities werenot registered under the Securities Act in reliance on the exemption set forthin Section 4(2) thereof. The Subordinated Debt Securities were issued to theTrust in consideration for the receipt of the net proceeds raised by the Trustfrom the sale of $8,000,000 in principal amount of the Trust’s Fixed RateCapital Trust Pass-through Securities (the “Trust Preferred Securities”).Sandler O’Neill & Partners, L.P. acted as the placement agent in connectionwith the offering of the Trust Preferred Securities.  The sale of the Trust Preferred Securitieswas part of a larger transaction arranged by Sandler O’Neill & Partners,L.P. pursuant to which the Trust Preferred Securities were deposited into aspecial purpose vehicle along with similar securities issued by a number ofother banks and the special purpose vehicle then issued its securities to thepublic (the “Pooled Trust Preferred Securities”). The Pooled Trust PreferredSecurities were sold by Sandler O’Neill & Partners, L.P. only (i) to thoseentities Sandler O’Neill & Partners, L.P. reasonably believed werequalified institutional  buyers (asdefined in Rule 144A under the Securities Act), (ii) to “accredited investors”(as defined in Rule 501(a)(1), (2), (3) or (7) or Regulation D promulgatedunder the Securities Act) or (iii) in offshore transactions in compliance with Rule903 of Regulation S under the Securities Act. The Trust Preferred Securitieswere not registered under the Securities Act in reliance on exemptions setforth in Rule 144A, Regulation D and Regulation S, as applicable. The proceedsof the sale were used in 2008 to retire the previously outstanding subordinateddebt securities of Community Valley Trust I and that trust was dissolved.

 

**Item 6.****           SelectedFinancial Data**

 

The “selected financial data”which follows has been derived from the audited Consolidated FinancialStatements of the Company and other data from our internal accounting system.The selected financial data should be read in conjunction with the auditedConsolidated Financial Statements and Notes thereto, and Management’sDiscussion and Analysis of Financial Condition and Results of Operations inItem 7 below. Statistical information below is generally based on average dailyamounts.

 

28

----

Table of Contents

 

**Selected Financial Data**

(dollars in thousands, except per share data)

 
| ** **                                                 | ** ** | **As of December 31,** | ** ** |
|------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                 | ** ** | **2008**                              | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Income Statement Summary**                               |       |                                  |       |   |   |   |   |   |   |   |   |
| Interest income                                            |       | $                                     | 37,315     |   | $ | 43,223 |   | $ | 40,814 |   | $ | 32,438 |   | $ | 24,980 |   |
| Interest expense                                           |       | $                                     | 10,365     |   | $ | 13,889 |   | $ | 9,532 |   | $ | 5,331 |   | $ | 4,056 |   |
| Net interest income before provision for loan  losses      |       | $                                     | 26,950     |   | $ | 29,334 |   | $ | 31,282 |   | $ | 27,107 |   | $ | 20,924 |   |
| Provision / credit for loan losses                         |       | $                                     | 3,742      |   | $ | (16 | ) | $ | 638 |   | $ | 825 |   | $ | 790 |   |
| Non-interest income                                        |       | $                                     | 8,939      |   | $ | 8,475 |   | $ | 6,769 |   | $ | 6,711 |   | $ | 6,019 |   |
| Non-interest expense                                       |       | $                                     | 28,276     |   | $ | 26,927 |   | $ | 25,160 |   | $ | 20,824 |   | $ | 16,740 |   |
| Income before provision for income taxes                   |       | $                                     | 3,871      |   | $ | 10,898 |   | $ | 12,253 |   | $ | 12,169 |   | $ | 9,413 |   |
| Provision for income taxes                                 |       | $                                     | 1,132      |   | $ | 4,439 |   | $ | 5,102 |   | $ | 4,971 |   | $ | 3,803 |   |
| Net Income                                                 |       | $                                     | 2,739      |   | $ | 6,459 |   | $ | 7,151 |   | $ | 7,198 |   | $ | 5,610 |   |
|                                                       |       |                                  |       |   |   |   |   |   |   |   |   |
| **Balance Sheet Summary**                                  |       |                                  |       |   |   |   |   |   |   |   |   |
| Total loans, net                                           |       | $                                     | 486,522    |   | $ | 441,350 |   | $ | 442,251 |   | $ | 401,221 |   | $ | 339,174 |   |
| Allowance for loan losses                                  |       | $                                     | (7,826     | ) | $ | (5,232 | ) | $ | (5,274 | ) | $ | (4,716 | ) | $ | (4,381 | ) |
| Investment securities held to maturity                     |       | $                                     | 634        |   | $ | 1,596 |   | $ | 1,777 |   | $ | 2,295 |   | $ | 2,582 |   |
| Investment securities available for sale                   |       | $                                     | 6,462      |   | $ | 4,668 |   | $ | 3,350 |   | $ | 4,381 |   | $ | 4,379 |   |
| Interest-bearing deposits in banks                         |       | $                                     | 2,576      |   | $ | 4,250 |   | $ | 2,278 |   | $ | 6,636 |   | $ | 8,715 |   |
| Cash and due from banks                                    |       | $                                     | 21,743     |   | $ | 31,714 |   | $ | 20,558 |   | $ | 18,988 |   | $ | 21,778 |   |
| Federal funds sold & other                        |       | $                                     | 36,605     |   | $ | 54,290 |   | $ | 42,070 |   | $ | 29,015 |   | $ | 46,440 |   |
| Premises and equipment, net                                |       | $                                     | 7,013      |   | $ | 17,905 |   | $ | 15,359 |   | $ | 11,221 |   | $ | 9,027 |   |
| Total interest-earning assets                              |       | $                                     | 532,799    |   | $ | 506,154 |   | $ | 491,726 |   | $ | 443,548 |   | $ | 401,290 |   |
| Total assets                                               |       | $                                     | 595,244    |   | $ | 580,620 |   | $ | 550,037 |   | $ | 494,777 |   | $ | 449,675 |   |
| Total interest-bearing deposits                            |       | $                                     | 444,326    |   | $ | 423,417 |   | $ | 407,868 |   | $ | 350,682 |   | $ | 318,266 |   |
| Total deposits                                             |       | $                                     | 526,485    |   | $ | 500,991 |   | $ | 484,856 |   | $ | 434,018 |   | $ | 399,059 |   |
| Total liabilities                                          |       | $                                     | 555,105    |   | $ | 529,646 |   | $ | 504,310 |   | $ | 453,222 |   | $ | 415,144 |   |
| Total shareholders’ equity                            |       | $                                     | 40,139     |   | $ | 50,974 |   | $ | 45,726 |   | $ | 41,555 |   | $ | 34,531 |   |
| **Per Share Data (1)**                                     |       |                                  |       |   |   |   |   |   |   |   |   |
| Basic earnings per share                                   |       | $                                     | 0.39       |   | $ | 0.87 |   | $ | 0.98 |   | $ | 1.00 |   | $ | 0.79 |   |
| Diluted earnings per share                                 |       | $                                     | 0.39       |   | $ | 0.85 |   | $ | 0.93 |   | $ | 0.95 |   | $ | 0.74 |   |
| Book value per weighted average share                      |       | $                                     | 5.78       |   | $ | 6.81 |   | $ | 6.28 |   | $ | 5.80 |   | $ | 4.86 |   |
| Cash dividends                                             |       | $                                     | 0.16       |   | $ | 0.32 |   | $ | 0.26 |   | $ | 0.16 |   | $ | 0.16 |   |
|                                                       |       |                                  |       |   |   |   |   |   |   |   |   |
| Weighted average common shares outstanding,  basic         |       | 6,940,876                             |       | 7,416,874 |   | 7,279,969 |   | 7,166,258 |   | 7,112,386 |   |
| Weighted average common shares outstanding,  diluted       |       | 7,008,838                             |       | 7,611,959 |   | 7,661,045 |   | 7,611,704 |   | 7,601,092 |   |
|                                                       |       |                                  |       |   |   |   |   |   |   |   |   |
| **Key Operating Ratios:**                                  |       |                                  |       |   |   |   |   |   |   |   |   |
| **Performance Ratios:**                                    |       |                                  |       |   |   |   |   |   |   |   |   |
| Return on Average Equity (2)                               |       | 6.11                                  | %          | 13.22 | % | 15.99 | % | 18.82 | % | 17.20 | % |
| Return on Average Assets (3)                               |       | 0.47                                  | %          | 1.13 | % | 1.38 | % | 1.51 | % | 1.34 | % |
| Net Interest Margin (4)                                    |       | 5.09                                  | %          | 5.68 | % | 6.62 | % | 6.32 | % | 5.70 | % |
| Dividend Payout Ratio (5)                                  |       | 41.03                                 | %          | 36.74 | % | 26.47 | % | 15.93 | % | 20.28 | % |
| Equity to Assets Ratio (6)                                 |       | 6.74                                  | %          | 8.78 | % | 8.64 | % | 8.02 | % | 7.82 | % |
| Net Loans to Total Deposits at Period End                  |       | 92.41                                 | %          | 88.10 | % | 91.21 | % | 92.44 | % | 84.99 | % |
| **Asset Quality Ratios:**                                  |       |                                  |       |   |   |   |   |   |   |   |   |
| Non Performing Loans to Total Loans                        |       | 3.01                                  | %          | 0.06 | % | 0.51 | % | 0.00 | % | 0.03 | % |
| Nonperforming Assets to Total Loans and Other  Real Estate |       | 3.41                                  | %          | 0.06 | % | 0.51 | % | 0.00 | % | 0.03 | % |
| Net Charge-offs to Average Loans                           |       | 0.24                                  | %          | 0.00 | % | 0.02 | % | 0.00 | % | 0.00 | % |
| Allowance for Loan Losses to Net Loans at  Period End      |       | 1.58                                  | %          | 1.17 | % | 1.18 | % | 1.16 | % | 1.16 | % |
|                                                       |       |                                  |       |   |   |   |   |   |   |   |   |
| **Capital Ratios:**                                        |       |                                  |       |   |   |   |   |   |   |   |   |
| Tier 1 Capital to Adjusted Total Assets                    |       | 8.1                                   | %          | 11.5 | % | 10.1 | % | 9.8 | % | 9.5 | % |
| Tier 1 Capital to Total Risk-Weighted  Assets              |       | 8.8                                   | %          | 13.1 | % | 10.9 | % | 11.4 | % | 11.3 | % |
| Total Capital to Total Risk-Weighted Assets                |       | 10.0                                  | %          | 14.1 | % | 11.9 | % | 12.5 | % | 12.5 | % |

 

----

(1)          All per share data and the average number ofshares outstanding have been retroactively restated on a split-adjusted basis.

(2)          Net income divided by average shareholders’equity.

(3)          Net income divided by average total assets.

(4)          Net interest income divided by average earningassets.

(5)          Dividends declared per share divided by netincome per share.

(6)          Average equity divided by average total assets.

 

29

----

Tableof Contents

 

**Item 7.****           Management’s Discussionand Analysis of Financial Condition and Results of Operations**

 

This discussion presents Management’s analysis of the financialcondition as of December 31, 2008 and 2007 and results of operations ofthe Company for each of the years in the three-year period ended December 31,2008. The discussion should be read in conjunction with the ConsolidatedFinancial Statements of the Company and the Notes related thereto presentedelsewhere in this Form 10-K Annual Report (see Item 8).

 

*Statements contained in this report that are not purely historical areforward looking statements within the meaning of Section 21E of theSecurities Exchange Act of 1934 as amended, including the Company’sexpectations, intentions, beliefs, or strategies regarding the future. Allforward-looking statements concerning economic conditions, rates of growth,rates of income or values as may be included in this document are based oninformation available to the Company on the date noted, and the Company assumesno obligation to update any such forward-looking statements. It is important tonote that the Company’s actual results could materially differ from those insuch forward-looking statements. Factors that could cause actual results todiffer materially from those in such forward-looking statements arefluctuations in interest rates, inflation, government regulations, economicconditions, customer disintermediation and competitive product and pricingpressures in the geographic and business areas in which the Company conductsits operations.*

 

**Critical Accounting Policies**

 

*General*

 

The Company’s significant accounting principles aredescribed in Note 1 of the consolidated financial statements and are essentialto understanding Management’s Discussion and Analysis of Results of Operationsand Financial Condition. Community Valley Bancorp’s consolidated financialstatements are prepared in accordance with accounting principles generallyaccepted in the United States of America (GAAP). The financial informationcontained within our statements is, to a significant extent, financialinformation that is based on measures of the financial effects of transactionsand events that have already occurred. Some of the Company’s accountingprinciples require significant judgment to estimate values of assets orliabilities. In addition, certain accounting principles require significantjudgment in applying the complex accounting principles to transactions todetermine the most appropriate treatment. The following is a summary of themore judgmental and complex accounting estimates and principles.

 

*Allowance for Loan Losses (ALL)*

 

The allowance for loan losses is management’sbest estimate of the probable losses that may be sustained in our loanportfolio. The allowance is based on two basic principles of accounting:  (1) SFAS No.5 which requires that lossesbe accrued when they are probable of occurring and estimable and (2) SFAS No. 114,which requires that losses be accrued on impaired loans based on thedifferences between the value of collateral, present value of future cash flowsor values that are observable in the secondary market and the loan balance.

 

The Company performs periodic and systematicdetailed evaluations of its lending portfolio to identify and estimate theinherent risks and assess the overall collectibility. These evaluations includegeneral conditions such as the portfolio composition, size and maturities ofvarious segmented portions of the portfolio such as secured, unsecured,construction, and Small Business Administration (“SBA”).  Additional factors includeconcentrations of borrowers, industries, geographical sectors, loan product,loan classes and collateral types, volume and trends of loan delinquencies andnon-accrual, criticized and classified assets and trends in the aggregate insignificant credits identified as watch list items. There are severalcomponents to the determination of the adequacy of the ALL. Each of thesecomponents is determined based upon estimates that can and do change when theactual events occur. The Company estimates the SFAS No. 5 portion of theALL based on the segmentation of its portfolio. For those segments that requirean ALL, the Company estimates loan losses on a monthly basis based upon itsongoing loan review process and analysis of loan performance. The Companyfollows a systematic and consistently applied approach to select the mostappropriate loss measurement methods and support its conclusions and rationalewith written documentation. One method of estimating loan losses for groups ofloans is through the application of loss rates to the groups’ aggregate loanbalances. Such rates typically reflect historical loss experience for eachgroup of loans, adjusted for relevant economic factors over a defined period oftime. The Company evaluates and modifies its loss estimation model as needed toensure that the resulting loss estimate is consistent with GAAP.

 

For individually impaired loans, SFAS No. 114 provides guidance onthe acceptable methods to measure impairment. Specifically, SFAS No. 114states that when a loan is impaired, the Company should measure impairmentbased on the present value of expected future principal and interest cash flowsdiscounted at the loan’s effective interest rate, except that as a practicalexpedient, a creditor may measure impairment based on a loan’s observablemarket price or the fair value of collateral, if the loan is collateraldependent. When developing the estimate of future cash flows for a loan, theCompany considers all available information reflecting past events and currentconditions, including the effect of existing environmental factors.

 

30

----

Tableof Contents

 

*Loan Sales and Servicing*

 

The Company originatesgovernment guaranteed loans and mortgage loans that may be sold in thesecondary market. The amounts of gains recorded on sales of loans and theinitial recording of servicing assets and interest only (I/O) strips is basedon the estimated fair values of the respective components. In recording theinitial value of the servicing assets and the fair value of the I/O stripsreceivable, the Company uses estimates which are made based on management’sexpectations of future prepayment and discount rates. Servicing assets areamortized over the estimated life of the related loan. I/O strips are notsignificant at December 31, 2008. These prepayment and discount rates werebased on current market conditions and historical performance of the variouspools of serviced loans. If actual prepayments with respect to sold loans occurmore quickly than projected the carrying value of the servicing assets may haveto be adjusted through a charge to earnings.

 

*Stock-Based Compensation*

 

Compensation cost is recognized for all share-basedpayments over the requisite service periods of the awards based on thegrant-date fair value of the options determined using the Black-Scholes-Mertonbased option valuation model.  Criticalassumptions that are assessed in computing the fair value of share-basedpayments include stock price volatility, expected dividend rates, the risk freeinterest rate and the expected lives of such options. Compensation costrecorded is net of estimated forfeitures expected to occur prior to vesting.For further information on the computation of the fair value of share-basedpayments, see Note 1 and 11 to the Consolidated Financial Statements in Part IIItem 8.

 

*Impairment of Investment Securities*

 

Investment securities are evaluated forother-than-temporary impairment on at least a quarterly basis and morefrequently when economic or market conditions warrant such an evaluation todetermine whether a decline in their value below amortized cost is other thantemporary. Management utilizes criteria such as the magnitude and duration ofthe decline, the financial condition of the issuer, rating agency changesrelated to the issuer’s securities and the intent and ability of the Bank toretain its investment in the issues for a period of time sufficient to allowfor an anticipated recovery in fair value, in addition to the reasonsunderlying the decline, to determine whether the loss in value is other thantemporary. The term “other than temporary” is not intended to indicate that thedecline is permanent, but indicates that the prospects for a near-term recoveryof value is not necessarily favorable, or that there is a lack of evidence tosupport a realizable value equal to or greater than the carrying value of theinvestment. Once a decline in value is determined to be other than temporary,the value of the security is reduced and a corresponding charge to earnings isrecognized. During 2008, the Company recognized an impairment charge of $1.4million on a trust preferred security it held for investment.

 

*Revenue Recognition*

 

The Company’s primary source of revenue is netinterest income, which is the difference between the interest income itreceives on interest-earning assets and the interest expense it pays oninterest-bearing liabilities, and (ii) fee income, which includes feesearned on deposit services, income from SBA lending, electronic-based cashmanagement services, mortgage brokerage fee income and merchant credit cardprocessing services. Interest income is recorded on an accrual basis. Note 1 tothe Consolidated Financial Statements offers an explanation of the process fordetermining when the accrual of interest income is discontinued on an impairedloan.

 

*Income Taxes*

 

The Company accounts for income taxes under theasset and liability method. Under the asset and liability method, deferred tax assetsand liabilities are recognized for the future tax consequences attributable todifferences between the financial statement carrying amounts of existing assetsand liabilities and their respective tax bases. Deferred tax assets andliabilities are measured using currently enacted tax rates applied to suchtaxable income in the years in which those temporary differences are expectedto be recovered or settled. The effect on deferred tax assets and liabilitiesof a change in tax rates is recognized in income in the period that includesthe enactment date. If future income should prove non-existent or less than theamount of deferred tax assets within the tax years to which they may beapplied, the asset may not be realized and our net income will be reduced.

 

31

----

Table of Contents

 

Since January 1,2007, the Company has accounted for uncertainty in income taxes under FinancialAccounting Standards Board (“FASB”) Interpretation No. 48, *Accounting for Uncertainty in Income Taxes*(“FIN 48”).  Under the provisions of FIN48, only tax positions that met the more likely than not recognition threshold,that the tax position would be sustained in a tax examination, on January 1,2007 were recognized or continue to be recognized.

 

When tax returns are filed, it is highlycertain that some positions taken would be sustained upon examination by thetaxing authorities, while others are subject to uncertainty about the merits ofthe position taken or the amount of the position that would be ultimatelysustained.  The benefit of a tax position is recognized in the financialstatements in the period during which, based on all available evidence, managementbelieves it is more likely than not that the position will be sustained uponexamination, including the resolution of appeals or litigation processes, ifany.  Tax positions taken are not offset or aggregated with otherpositions.  Tax positions that meet the more-likely-than-not recognitionthreshold are measured as the largest amount of tax benefit that is more than50 percent likely of being realized upon settlement with the applicable taxingauthority.  The portion of the benefits associated with tax positionstaken that exceeds the amount measured as described above is reflected as aliability for unrecognized tax benefits in the accompanying balance sheet alongwith any associated interest and penalties that would be payable to the taxingauthorities upon examination.

 

###### **Summary of Performance**

######  

For 2008, net income was $2.74 million, compared to the $6.46 millionearned in 2007 and $7.15 million in 2006. Net income per diluted share was $.39for 2008, as compared to $.85 during 2007 and $.93 in 2006. The Company’sReturn on Average Assets (“ROAA”) was .47% and Return on Average Equity (“ROAE”)was 6.11% in 2008, as compared to 1.13% and 13.22%, respectively, in 2007 and1.38% and 15.99%, respectively, for 2006.

 

The downward movement in rates of 400 basis points by the FOMC (FederalOpen Market Committee), throughout 2008 had a negative impact on the netinterest margin as the compression of interest rates decreased net interestincome by $2.4 million from 2007 to 2008. The economic downturn and the downward trends in the real estate markethad a negative effect on our construction loan business and the resultingmortgage loans that in the past had provided substantial gains when the loanssold on the secondary market. Even in the current environment the Company wasable to continue to sell several USDA Business and Industry guaranteed loansand SBA loans allowing us to realize gains during 2008 approximately equal to73% of the gains in 2007. Increases in non interest expenses are, primarilyrelated to the leases on seven buildings the Company sold and leased backduring 2008, which was offset by other non interest income as we recognized aportion of the gain on the sale leaseback and an impairment charge on asecurity in the fourth quarter.  Theseexpenses were partially offset by a decrease in salaries and employeebenefits.  Non interest income increasedprimarily due to service charges on deposit accounts and the gain recognized onthe sale leaseback.

 

###### **Results of Operations**

######  

**The Impact of Changes in Assets and Liabilities to Net Interest Incomeand Net Interest Margin**

 

We monitor asset and deposit levels, developments and trends ininterest rates, liquidity, capital adequacy and marketplace opportunities.  We respond to all of these to protect and maximizeincome while managing risks within acceptable levels as set by the Company’spolicies.  In additional alternativebusiness plans and contemplated transactions are analyzed for their impact onthe level of risk assumed by the Company. This process, known as asset/liability management, is carried out bychanging the maturities and relative proportions of the various types of loans,investments, deposits and other borrowings in ways described below.  The management staff responsible forasset/liability management operates under the oversight of the Asset/LiabilityCommittee and provides regular reports to the Board of Directors.  Board approval is obtained for major actionsor the occasional exception to policy.

 

###### **Net Interest Income and Net Interest Margin**

######  

The Company earns income from two primary sources. The first is netinterest income brought about by income from the successful deployment ofearning assets less the costs of interest-bearing liabilities. The second isnon-interest income, which generally comes from customer service charges andfees, but can also result from non-customer sources such as gains on loansales. The majority of the Company’s non-interest expenses are operating costswhich relate to providing a full range of banking services to our customers.

 

Net interest income, which is simply total interest income (includingfees) less total interest expense, was $26.9 million in 2008 compared to $29.3million and $31.3 million in 2007 and 2006, respectively. This represents adecrease of 8.2% in 2008 from 2007 and a decrease of 6.2% in 2007 from 2006.The amount by which interest income exceeds interest expense depends on severalfactors. Among those factors are yields on earning assets, the cost ofinterest-bearing liabilities, the relative volume of total earning assets andtotal interest-bearing liabilities, and the mix of products which comprise the 

 

32

----

Tableof Contents

 

Company’s earning assets, deposits, and other interest-bearingliabilities. Change in the amount and mix of interest-earning assets andinterest-bearing liabilities is referred to as “volume change.”  Change in interest rates earned on assets andrates paid on deposits and other borrowed funds is referred to as “rate change.”

 

The Volume and Rate Variances table which follows sets forth the dollaramount of changes in interest earned and paid for each major category ofinterest-earning assets and interest-bearing liabilities and the amount ofchange attributable to changes in average balances (volume) or changes inaverage interest rate. The calculation is as follows: the change due to increase or decrease in volume isequal to the increase or decrease in the average balance times the prior period’srate. The change due to an increase or decrease in the rate is equal to theincrease or decrease in the average rate times the current period’s balance.The variances attributable to both the volume and rate changes have beenallocated to the change in rate.

 
| ** **                         | ** ** | **Years Ended December 31,**    | ** ** |
|------------------------------------|------------|------------------------------------------------|------------|
| ** **                         | ** ** | **2008 over 2007**                   | ** ** | **2007 over 2006** | ** ** |
| ** **                         | ** ** | **Increase (decrease) due to:** | ** ** | **Increase (decrease) due to:** | ** ** |
| ** **                         | ** ** | **Volume**                                     | ** ** | **Rate** | ** ** | **Net** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **Net** | ** ** |
| **Earning Assets:**                |       |                                           |       |   |   |   |   |   |   |   |   |   |   |
| Loans                              |       | $                                              | 2,218      |   | $ | (6,641 | ) | $ | (4,423 | ) | $ | 1,058 |   | $ | (331 | ) | $ | 728 |   |
| Federal funds sold                 |       | (977                                           | )          | (896 | ) | (1,873 | ) | 1,685 |   | (56 | ) | 1,629 |   |
| Investment securities:             |       |                                           |       |   |   |   |   |   |   |   |   |   |   |
| Taxable                            |       | 170                                            |       | 11 |   | 181 |   | (14 | ) | 62 |   | 48 |   |
| Non-taxable (1)                    |       | —                                         |       | — |   | — |   | (0 | ) | (1 | ) | (0 | ) |
| Interest bearing deposits in banks |       | 394                                            |       | (187 | ) | 207 |   | (77 | ) | 80 |   | 4 |   |
| Total                              |       | 1,805                                          |       | (7,713 | ) | (5,908 | ) | 2,652 |   | (245 | ) | 2,408 |   |
|                               |       |                                           |       |   |   |   |   |   |   |   |   |   |   |
| **Interest-bearing liabilities:**  |       |                                           |       |   |   |   |   |   |   |   |   |   |   |
| Interest bearing deposits:         |       |                                           |       |   |   |   |   |   |   |   |   |   |   |
| NOW and money market deposits      |       | 25                                             |       | (410 | ) | (385 | ) | (294 | ) | 21 |   | (273 | ) |
| Savings deposits                   |       | 38                                             |       | (1,566 | ) | (1,528 | ) | 676 |   | 2,554 |   | 3,230 |   |
| Time deposits                      |       | 396                                            |       | (1,659 | ) | (1,263 | ) | 62 |   | 1,037 |   | 1,099 |   |
| Total interest bearing deposits    |       | 459                                            |       | (3,635 | ) | (3,176 | ) | 444 |   | 3,612 |   | 4,056 |   |
|                               |       |                                           |       |   |   |   |   |   |   |   |   |   |   |
| Other borrowings                   |       | (172                                           | )          | (176 | ) | (348 | ) | 369 |   | (73 | ) | 296 |   |
| Total Interest bearing liabilities |       | 287                                            |       | (3,811 | ) | (3,524 | ) | 813 |   | 3,539 |   | 4,352 |   |
| Net interest margin/income         |       | $                                              | 1,518      |   | $ | (3,902 | ) | $ | (2,384 | ) | $ | 1,839 |   | $ | (3,784 | ) | $ | (1,944 | ) |

 

----

(1)          Yields on tax exempt income have not beencomputed on a tax equivalent basis.

 

The Company’s net interest margin is its net interest income expressedas a percentage of average earning assets. The Company’s net interest marginfor 2008 was 5.09% a decrease of 59 basis points from the 5.68% reported in2007. For the year 2006, this margin was 6.62%. The following Distribution,Rate and Yield table shows, for each of the past three years, the rates earnedon each component of the Company’s investment and loan portfolio and the ratespaid on each segment of the Company’s interest bearing liabilities. That sametable also shows the Company’s average daily balances for each principalcategory of assets, liabilities and shareholders’ equity, the amount ofinterest income or interest expense, and the average yield or rate for eachcategory of interest-earning asset and interest-bearing liability along withthe net interest margin for each of the reported periods.

 

33

----

Tableof Contents

 

**Distribution, Rate & Yield**

 
| ** **                                            | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                            | ** ** | **2008 (a)**                          | ** ** | **2007 (a)** | ** ** | **2006 (a)** | ** ** |
| **(In thousands, except percentages)** | ** ** | **Average   Balance**                 | ** ** | **Interest** | ** ** | **Avg   Rate** | ** ** | **Average   Balance** | ** ** | **Interest** | ** ** | **Avg   Rate** | ** ** | **Average   Balance** | ** ** | **Interest** | ** ** | **Avg   Rate** | ** ** |
| **Assets**                                            |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Investments:                                          |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Federal funds  sold                                   |       | $                                          | 31,086     |   | $ | 602 |   | 1.94 | % | $ | 51,358 |   | $ | 2,475 |   | 4.82 | % | $ | 17,164 |   | $ | 846 |   | 4.93 | % |
| Taxable                                               |       | 7,054                                      |       | 410 |   | 5.81 | % | 4,053 |   | 229 |   | 5.66 | % | 4,403 |   | 181 |   | 4.12 | % |
| Non-taxable (1)                                       |       | 1,386                                      |       | 65 |   | 4.69 | % | 1,377 |   | 65 |   | 4.70 | % | 1,370 |   | 65 |   | 4.74 | % |
| Interest bearing  deposits in banks                   |       | 7,950                                      |       | 389 |   | 4.89 | % | 2,509 |   | 182 |   | 7.24 | % | 4,409 |   | 178 |   | 4.04 | % |
| Total investments                                     |       | 47,476                                     |       | 1,466 |   | 3.09 | % | 59,297 |   | 2,951 |   | 4.98 | % | 27,346 |   | 1,270 |   | 4.65 | % |
| Loans:                                                |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Agricultural                                          |       | 33,097                                     |       | 2,301 |   | 6.95 | % | 30,832 |   | 2,818 |   | 9.14 | % | 28,129 |   | 2,578 |   | 9.17 | % |
| Commercial                                            |       | 84,422                                     |       | 6,954 |   | 8.24 | % | 70,732 |   | 7,242 |   | 10.24 | % | 67,608 |   | 6,655 |   | 9.84 | % |
| Real estate                                           |       | 305,871                                    |       | 22,482 |   | 7.35 | % | 307,430 |   | 26,472 |   | 8.61 | % | 307,921 |   | 27,167 |   | 8.82 | % |
| Consumer                                              |       | 58,818                                     |       | 4,112 |   | 6.99 | % | 48,039 |   | 3,740 |   | 7.79 | % | 41,461 |   | 3,144 |   | 7.58 | % |
| Total loans                                           |       | 482,208                                    |       | 35,849 |   | 7.43 | % | 457,033 |   | 40,272 |   | 8.81 | % | 445,119 |   | 39,544 |   | 8.88 | % |
| Total earning  assets (2)                             |       | 529,684                                    |       | 37,315 |   | 7.04 | % | 516,330 |   | 43,223 |   | 8.37 | % | 472,465 |   | 40,814 |   | 8.64 | % |
| Non earning  assets                                   |       | 47,667                                     |       |   |   |   |   | 56,122 |   |   |   |   |   | 45,159 |   |   |   |   |   |
| Average total  assets                                 |       | $                                          | 577,351    |   |   |   |   |   | $ | 572,452 |   |   |   |   |   | $ | 517,624 |   |   |   |   |   |
|                                                  |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| **Liabilities &  Shareholders’ Equity** |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest bearing  deposits:                           |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| NOW                                                   |       | $                                          | 117,903    |   | $ | 634 |   | 0.54 | % | $ | 116,403 |   | $ | 919 |   | 0.79 | % | $ | 137,358 |   | $ | 1,210 |   | 0.88 | % |
| Savings                                               |       | 115,116                                    |       | 2,039 |   | 1.77 | % | 113,913 |   | 3,567 |   | 3.13 | % | 37,893 |   | 337 |   | 0.89 | % |
| Money market                                          |       | 33,357                                     |       | 531 |   | 1.59 | % | 32,440 |   | 631 |   | 1.94 | % | 40,066 |   | 616 |   | 0.88 | % |
| TDOAs and IRAs                                        |       | 7,941                                      |       | 298 |   | 3.75 | % | 7,632 |   | 343 |   | 4.49 | % | 6,537 |   | 242 |   | 3.70 | % |
| Certificates of  deposit < $100,000                |       | 73,815                                     |       | 2,686 |   | 3.64 | % | 77,341 |   | 3,655 |   | 4.73 | % | 78,661 |   | 3,242 |   | 4.12 | % |
| Certificates of  deposit > $100,000                |       | 85,683                                     |       | 3,407 |   | 3.98 | % | 74,230 |   | 3,656 |   | 4.93 | % | 72,513 |   | 3,061 |   | 4.22 | % |
| Total interest  bearing deposits                      |       | 433,815                                    |       | 9,595 |   | 2.21 | % | 421,959 |   | 12,771 |   | 3.03 | % | 373,028 |   | 8,708 |   | 2.33 | % |
| Borrowed Funds:                                       |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Other borrowings                                      |       | 11,445                                     |       | 770 |   | 6.73 | % | 13,523 |   | 1,118 |   | 8.27 | % | 9,334 |   | 824 |   | 8.81 | % |
| Total borrowed  funds                                 |       | 11,445                                     |       | 770 |   | 6.73 | % | 13,523 |   | 1,118 |   | 8.27 | % | 9,334 |   | 824 |   | 8.81 | % |
| Total interest  bearing liabilities                   |       | 445,260                                    |       | 10,365 |   | 2.33 | % | 435,482 |   | 13,889 |   | 3.19 | % | 382,362 |   | 9,532 |   | 2.49 | % |
| Demand deposits                                       |       | 73,545                                     |       |   |   |   |   | 81,860 |   |   |   |   |   | 83,427 |   |   |   |   |   |
| Other liabilities                                     |       | 13,718                                     |       |   |   |   |   | 6,251 |   |   |   |   |   | 7,112 |   |   |   |   |   |
| Total liabilities                                     |       | 532,523                                    |       |   |   |   |   | 523,593 |   |   |   |   |   | 472,901 |   |   |   |   |   |
| Shareholders’  equity                            |       | 44,828                                     |       |   |   |   |   | 48,859 |   |   |   |   |   | 44,723 |   |   |   |   |   |
| Average  liabilities and equity                       |       | $                                          | 577,351    |   |   |   |   |   | $ | 572,452 |   |   |   |   |   | $ | 517,624 |   |   |   |   |   |
|                                                  |       |                                       |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest  income & margin (3)            |       |                                       |       | $ | 26,950 |   | 5.09 | % |   |   | $ | 29,334 |   | 5.68 | % |   |   | $ | 31,282 |   | 6.62 | % |

 

----

(a)          Average balances are obtained from the best available daily or monthlydata.

(1)          Yields on tax exempt income have not been computed on a tax equivalentbasis.

(2)          Non-accrual loans have been included in total loans for purposes oftotal earning assets.

(3)          Represents net interest income as a percentage of averageinterest-earning assets.

(4)            Yields and amounts earned on loans includeloan fees of $1,761,000, $1,936,000 and $2,450,000 for the years ended December 31,2008, 2007 and 2006 respectively.

 

During 2008, the Company’s net interest margin declined primarily as aresult of the change in interest rates as the Federal Open Market Committee,(FOMC) lowered rates by 400 basis points throughout the year. Averageinvestments, primarily Federal funds sold, decreased by 19.9% while loangrowth, on an average basis, increased by 5.5%.    Although mitigated by the decline in therates paid on interest bearing liabilities, this combination resulted in anoverall decrease of 59 basis points in net the interest margin. On an averagebasis, the rates on loans decreased by 138 basis points resulting in a decreasein interest income of $6.6 million. This decrease in rates was offset by theincrease in the average volume of loans of $25.2 million that generated anadditional $2.2 million in loan related interest income. On an average basis,the rate on investments decreased by 189 basis points resulting in a decreasein interest income of $1.1 million, additionally the decrease in average volumeof investment securities of $11.8 million resulted in a decrease in interestincome of $413 thousand.  Overall,interest income on earning assets decreased by $5.9 million.

 

34

----

Tableof Contents

 

A large portion of the Bank’s loans carry variable rates and re-priceimmediately, subject to certain floors, versus a large base of core depositswhich are generally slower to re-price. Interest expense decreased in 2008 asrates decreased while  the Company’s mixof deposits remained consistent with the 2007 levels with the exception of thedecrease in 2008 in non interest bearing demand deposits.  The average rates paid on interest bearingdeposits for 2008 decreased 82 basis points to 2.21% compared to 3.03% in 2007 and 2.33% in 2006. The changes indeposit rates in 2008 compared to 2007 were primarily due to the changes ininterest rates brought on by Federal Reserve Board actions as discussedpreviously. The average rates that are paid on deposits generally trail behindthese changes for two reasons: (1) financial institutions do not alwayschange deposit rates with each small increase or decrease in short-term rates;and (2) with time deposit accounts, even when new offering rates areestablished, the average rates paid during the year are a blend of the ratepaid on all of the individual accounts. Only new accounts and those that matureand are renewed will bear the new rate. The average balances of interestbearing liabilities of $445.3 million were $9.8 million (2.2%) higher in 2008than 2007.  On an average basis, NOWaccount deposits were up $1.5 million, savings account deposits were up $1.2million, money market account deposits were up $917 thousand and certificate ofdeposit balances were up $7.9 million. The average balance of non-interest bearing demand deposits decreased by$8.3 million from 2007 to 2008.

 

From 2007 to 2008, the Company’s average loan portfolio grew byapproximately $25.2 million, or 5.5%, building on the growth of $11.9 million,or 2.7% in 2007 over 2006.  The earningson that growth, net of associated funding costs, are a significant contributorto net interest income. During 2008, the loan portfolio averaged 83.5% of totalassets, while for 2007 and 2006 such balances represented 80.4% and 86%,respectively, of average assets.

 

Based on current economic conditions, the Company expects moderatedecreases in the rates paid on interest-bearing liabilities and rates earned onboth the investment and loan portfolio during 2009. It is anticipated that theFederal Reserve Board will not adjust interest rates in the foreseeablefuture.  It is also anticipated that theCompany’s net interest margin may improve as time deposits reprice and loanrates remain stable.

 

###### **Non-interest Income and Non-interest Expense**

######  

For the year 2008, non-interest income increased 464,000 or (5.5%) to$8,939,000 as compared to $8,475,000 for 2007. Non interest income in 2006 was$6,769,000. The primary sources of non-interest income for the Company areservice charges on deposit accounts, gains on the sale of loans, loan servicingincome, the amortization of the gain on the sale lease back of certainproperties beginning in 2008, alternative investment fees earned on the salesof non-deposit investment products, merchant credit card fees, and earningsfrom changes in the cash surrender value of bank owned life insurance. Servicecharges on deposit accounts and loan sales income in 2008 accounted for 43.7%and 12.3%, respectively, of total non-interest income, as compared to 40.4% and17.8%, respectively, for 2007 and 39.7% and 23.3%, respectively, for 2006. Loanservicing income, alternative investment fees, merchant credit card fees, andearning from cash surrender value of bank owned life insurance for 2008 were6.2%, 6.1%, 4.6%, and 6.3% respectively, of total non-interest income, ascompared to 4.7%, 4.2%, 4.8%, and 4.5% respectively, for 2007 and 6.8%, 5.2%,5.6%, and 4.9% respectively, for 2006. Other non-interest income represented 20.8%, 23.7%, and 14.6%respectively in 2008, 2007, and 2006. Included in other non-interest income for 2008 was the amortization ofthe gain on the sale and lease back of the seven properties which totaled$326,000 or 3.6%.

 

The primary source of non-interest income during 2008 was from servicecharges on deposit accounts which totaled $3,904,000, an increase of$482,000.  This was followed by othernon-interest income totaling $1,859,000 which was a decrease of $153,000largely due to the one time pre tax gain of $730,000 realized in the thirdquarter of 2007 from the sale of mortgage servicing rights, offset by the gainrecognized of $326,000 for the sale lease back of certain properties.  The gain of $5,579,000 is being amortized ona straight line basis over 15 years. The increase in service charges on depositaccounts was primarily a result of the fees charged on additional depositaccounts opened during the year, and the overdraft privilege deposit productwhich on a year over year basis increased $296,000. Gains on sales of loansdecreased $404,000 from $1,506,000 in 2007 to $1,102,000 in 2008. This was aresult of the lower volume of loans sold during 2008. The real estate marketcontinued to soften in all of the areas we serve which resulted in more homesfor sale thereby creating an environment more advantageous to the buyer thanthe seller.

 

The loan portfolio also includes loans which are 75% to 90% guaranteedby the Small Business Administration (SBA), U.S. Department of Agriculture,Rural Business-Cooperative Service (RBS) and Farm Services Agency (FSA). Theguaranteed portion of these loans may be sold to a third party, with theCompany retaining the unguaranteed portion. The Company generally receives apremium in excess of the adjusted carrying value of the loan at the time ofsale.

 

35

----

Tableof Contents

 

The portfolio of SBA, RBS and FSA government guaranteed loans beingserviced by the Company increased by 14% from 2007 to 2008. The increase inloan servicing income of $161,000 from $395,000 in 2007 to $556,000 in 2008 wasdue to the retention of the servicing rights on these loans rather than theselling the loans with the servicing released as the premiums offered on theseloans during 2008 were not as significant as those offered in prior years.

 

Alternative investment fees earned on the sales of non-depositinvestment products increased by $4,000 in 2007 compared to 2006 primarily as aresult of more sales throughout the year.

 

Merchant credit card processing fees increased $6 thousand from $403thousand in 2007, to $409 thousand in 2008. Management is currently negotiatingto sell this business to a third party provider and anticipates the transactionwill finalize in March 2009.

 

The operating efficiency ratio is often used to compare the Company’sexpenses to those of other financial institutions.  This ratio takes factors in that for manyfinancial institutions some of their income is not asset-based, it is based onfees for services provided rather than income earned from a spread between theinterest earned on assets and interest paid on liabilities.  The operating efficiency ratio measures whatportion of each dollar of net revenue is spent earning that revenue.  With a portion of the Company’s revenuescoming from such areas as the Insurance Agency, Payroll Services and MerchantServices, i.e., from programs that require operating expenses to run but arenot related to assets on the Company’s balance sheet, management focuses moreon this ratio than the operating expense to assets ratio.    The Company is increasingly focused onenhancing its fee income. Based on the Company’s efficiency ratio of 80.4% for2008, 70.6% for 2007 and 65.8% for 2006 as compared to the 55% and lower ratiosof certain major financial institutions, it is expected that this focus willcontinue for the foreseeable future.

 

The Company’s total non-interest expense increased to $28.3 million in2008, as compared to $26.9 million in 2007, and $25.2 million in 2006.

 

Salaries and employee benefits decreased $1,045,000 or 7.2% from 2007to 2008.   Included within salaries andbenefits are actual salaries, bonuses, commissions, retirement benefits,payroll taxes, and stock option expense. This decrease was primarily the result of a decrease in bonuses andcommissions paid during 2008 and a decrease in the number of employees.  The increase in salaries and benefits in 2007compared to 2006 was $205,000 or 1.3%. Full time equivalent employees were 248,260 and 263 at December 31, 2008, 2007 and 2006, respectively.  Benefit costs and employer taxes decreasedcommensurate with the salaries.  In February 2009additional reductions in staffing resulted in a decrease of 14 full timeequivalent employees.   It is management’sopinion that the Company can operate efficiently with the current level ofstaffing.

 

Occupancy and equipment expenses were $5,424,000, an increase of$1,203,000 or 28.5% when compared to the 2007 total of $4,221,000. Much of theincrease in occupancy expense was related to the additional rent associatedwith the sale and lease back of the seven properties in February of2008.  The increase in occupancy expensesin 2007 compared to 2006 was $741,000 or 21.3% primarily related to the newheadquarters building as well as furniture, fixtures and equipment for the newAnderson and Redding branches which opened in the third quarter of 2007.

 

The majority of the decrease in professional services costs of $355,000from 2007 to 2008 relates to the reduced amount of earnings credit for vendorservices to a title and escrow company the Bank has had a long-termrelationship with.  The increase in 2007of $329,000 compared to 2006 was due to outsourcing of the internal audit workand the process of complying with the requirements of the Sarbanes-OxleyAct.  Advertising and marketing expensesincreased by 51% in 2008 from 2007 largely due to a mass mailing andpromotional campaign provided by a third party vendor used for the acquisitionof new checking accounts.   Theseexpenses increased by 13.9% in 2007 from 2006 as we promoted the new branches.

 

Expenses representing telephone and data communications, postage andmail, stationery and supplies, director fees and retirement accruals,advertising and promotion, and other expenses totaled $5,560,000 for 2007compared to $5,319,000 in 2007 and $4,931,000 in 2006, an increase of 4.5% and7.9% on a year over year basis. Management considers this increase in expensescommensurate with the growth and operations of the Company.  Additionally, in the fourth quarter of 2008,the Company recognized an impairment charge of $1,489,000 on collateralizeddebt obligations that are backed by trust-preferred securities.

 

The Company issues stock options under two shareholder approvedstock-based compensation plans, the Community Valley Bancorp 1997 and 2000Stock Option Plans.  The Plans do notprovide for the settlement of awards in cash and new shares are issued uponexercise of the options.  The plansrequire that the option price may not be less than the fair market value of thestock at the date the option is granted, and that the stock must be paid for infull at the time the option is exercised. The options expire on a datedetermined by the Board of Directors, but not later than ten years from thedate of grant. The vesting period is determined by the Board of Directors andis generally over five years; however, nonstatutory options granted during 1997vested immediately. Under the 1997 plan, 8,254 shares of common stock remainreserved for issuance to employees and directors, and the related options areexercisable until their expiration. However, no new options will be grantedunder this plan. Under the Company’s 2000 stock option plan, 341,977 shares ofcommon stock remain reserved for issuance to employees and directors, of which96,916 shares are available for future grants.

 

36

----

Table of Contents

 

Management estimates the fairvalue of each option award as of the date of the grant using aBlack-Sholes-Merton option pricing model. Expected volatility is based on historical volatility of the Company’sstock over a preceding period commensurate with the expected term of theoption.  The “simplified” methoddescribed in SEC Staff Accounting Bulletin No. 107, as amended by SECStaff Accounting Bulletin 110, was used to determine the expected term of theCompany’s options for 2008, 2007 and 2006. The risk free interest rate for the expected term of the option is basedon U.S. Treasury yield curve in effect at the time of the grant.  The expected dividends yield was determinedbased on the budgeted cash dividends of the Company at the time of thegrant.  In addition to these assumptions,management makes estimates regarding pre-vesting forfeitures that will impacttotal compensation expense recognized under the Plan.

 

At December 31, 2008, the total compensation cost related tonon-vested stock option awards granted to employees under the Company’s stockoption plans but not yet recognized was $93,000. Stock option compensationexpense is recognized on a straight-line basis over the vesting period of theoption. This cost is expected to be recognized over a weighted averageremaining period of 2.0 years and will be adjusted for subsequent changes inestimated forfeitures.  See Notes 1 and11 to the audited Consolidated Financial Statements in Item 8.

 

**Non Interest Income/Expense**

(dollars in thousands, unaudited)

 
| ** **                                                       | ** ** | **2008**   | ** ** | **% of Total** | ** ** | **2007**   | ** ** | **% of Total** | ** ** | **2006**   | ** ** | **% of Total** | ** ** |
|------------------------------------------------------------------|------------|------------|------------|--------------------------|------------|------------|------------|--------------------------|------------|------------|------------|--------------------------|------------|
| **Non-interest income:**                                         | ** ** | ** ** | ** ** | ** **               | ** ** | ** ** | ** ** | ** **               | ** ** | ** ** | ** ** | ** **               | ** ** |
| Service charges on deposit accounts                              |       | $          | 3,904      |                     | 43.67      | %          | $          | 3,422                    |       | 40.37      | %          | $                        | 2,686      |   | 39.68 | % |
| Gain on sale of loans                                            |       | 1,102      |       | 12.33                    | %          | 1,506      |       | 17.77                    | %          | 1578       |       | 23.31                    | %          |
| Loan servicing income                                            |       | 556        |       | 6.22                     | %          | 395        |       | 4.66                     | %          | 457        |       | 6.75                     | %          |
| Alternative investment fees                                      |       | 545        |       | 6.10                     | %          | 354        |       | 4.18                     | %          | 350        |       | 5.17                     | %          |
| Merchant card processing fees                                    |       | 409        |       | 4.58                     | %          | 403        |       | 4.76                     | %          | 381        |       | 5.63                     | %          |
| Earnings from cash surrender value of bank  owned life insurance |       | 564        |       | 6.31                     | %          | 383        |       | 4.52                     | %          | 330        |       | 4.88                     | %          |
| Other                                                            |       | 1,859      |       | 20.80                    | %          | 2,012      |       | 23.74                    | %          | 987        |       | 14.58                    | %          |
| Total non-interest income                                        |       | $          | 8,939      |                     | 100.00     | %          | $          | 8,475                    |       | 100.00     | %          | $                        | 6,769      |   | 100.00 | % |
| As a percentage of average earning assets                        |       | 1.69       | %          |                     |       | 1.64       | %          |                     |       | 1.43       | %          |                     |       |
|                                                             |       |       |       |                     |       |       |       |                     |       |       |       |                     |       |
| **Non-interest expense:**                                        |       |       |       |                     |       |       |       |                     |       |       |       |                     |       |
| Salaries and employee benefits                                   |       | $          | 14,585     |                     | 51.58      | %          | $          | 15,630                   |       | 58.05      | %          | $                        | 15,425     |   | 61.31 | % |
| Occupancy and equipment                                          |       | 5,425      |       | 19.19                    | %          | 4,221      |       | 15.68                    | %          | 3,480      |       | 13.83                    | %          |
| Professional fees                                                |       | 1,161      |       | 4.11                     | %          | 1,516      |       | 5.63                     | %          | 1,187      |       | 4.72                     | %          |
| Telephone and postage                                            |       | 659        |       | 2.33                     | %          | 594        |       | 2.21                     | %          | 630        |       | 2.50                     | %          |
| Stationery and supply costs                                      |       | 747        |       | 2.64                     | %          | 828        |       | 3.08                     | %          | 601        |       | 2.39                     | %          |
| Director fees and retirement accrual                             |       | 508        |       | 1.80                     | %          | 482        |       | 1.79                     | %          | 450        |       | 1.79                     | %          |
| Advertising and promotion                                        |       | 1,136      |       | 4.02                     | %          | 752        |       | 2.79                     | %          | 660        |       | 2.62                     | %          |
| Impairment recognized on investment  security                    |       | 1,489      |       | 5.27                     | %          | —     |       | 0.00                     | %          | —     |       | 0.00                     | %          |
| Regulatory assessments                                           |       | 382        |       | 1.35                     | %          | 140        |       | 0.52                     | %          | 116        |       | 0.46                     | %          |
| Other                                                            |       | 2,184      |       | 7.72                     | %          | 2,764      |       | 10.26                    | %          | 2,611      |       | 10.38                    | %          |
| Total non-interest expense                                       |       | $          | 28,276     |                     | 100.00     | %          | $          | 26,927                   |       | 100.00     | %          | $                        | 25,160     |   | 100.00 | % |
| As a percentage of average earning assets                        |       | 5.34       | %          |                     |       | 5.22       | %          |                     |       | 5.33       | %          |                     |       |

 

###### **Provision for Loan Losses**

######  

Credit risk is inherent in the business of making loans. The Companysets aside an allowance for loan losses through a provision charged toearnings. The charges are shown in the income statements as provisions for loanlosses, and specifically identifiable and quantifiable losses are immediatelycharged off against the allowance.

 

The Company’s provisions for loan losses and undisbursed commitments in2008, 2007, and 2006 were $3,175,000, $225,000, and $775,000 respectively. Theamounts allocated to the provision and the undisbursed commitments were$3,742,000 and $(567,000) respectively for 2008, $(16,000) and $241,000 for2007 and $638,000 and $137,000 for 2006. 

 

37

----

Table of Contents

 

The loan loss provision is determined by conducting a monthlyevaluation of the adequacy of the Company’s allowance for loan losses, andcharging the shortfall, if any, to the current month’s expense. This has theeffect of creating variability in the amount and frequency of charges to theCompany’s earnings. The procedures for monitoring the adequacy of theallowance, as well as detailed information concerning the allowance itself, areincluded below under “Allowance for Loan Losses.”

 

###### **Income Taxes**

######  

As indicated in Note 13 in the Notes to the Consolidated FinancialStatements in Item 8, the provision for income taxes is the sum of twocomponents, the provision for current taxes and the deferred taxes. Theprovision for current taxes results from applying the current tax rate totaxable income, and represents the actual current income tax liability. Someitems of income and expense are recognized in different years for tax purposesthan when applying accounting principles generally accepted in the UnitedStates of America, however, leading to differences between the Company’s actualtax liability and the amount accrued for this liability based on book income.These temporary timing differences comprise the deferred portion of the Company’stax provision.

 

Most of the Company’s temporary differences involve recognizing moreexpenses in its financial statements than it has been allowed to deduct for taxpurposes, and therefore the Company normally carries a net deferred tax asseton its books. At December 31, 2008, the Company’s $10.3 million netdeferred tax asset was primarily due to temporary differences in the reportedallowance for loan losses, deferred compensation, and future benefit of statetax deduction offset by the temporary differences related to certain deferredtax liabilities.

 

###### **Financial Condition**

######  

The following discussion of the financial condition of the Company isgrouped into earning assets, comprised of loans and investments; non-earningassets, comprised of cash and due from banks, premises and equipment and otherassets; liabilities, consisting of deposits and other borrowings; capitalresources; and liquidity and market risk. Each section provides details whereapplicable on volume, rates of change, and significance relative to the overallactivities of the Company.

 

A comparison between the summary year-end balance sheets for 2004through 2008 was presented previously in the table of Selected Financial Data(see Item 6 above). As indicated in that table, the Company’s total assets anddeposits have grown each year for the past four years, with asset growth, interms of total dollars, most pronounced in 2006 when the Company grew by $55million, or 11.2%.  This was followed bygrowth in the Company’s total assets during 2005 of $45 million or 10% andgrowth in the Company’s total assets during 2007 of approximately $30 million,or 5.6%. The growth in total assets during 2008 was approximately $15 million,or 2.5%.

 

The mix of our core deposit base changed very little during 2008 as NOWand Money Market account balances, on an average basis, increased by 1.3% and2.8% respectively while savings balances increased by 1.1% and certificates ofdeposit balances increased by 5.2%.  Theweighted average rates of our NOW and Money market account balances were .54%and 1.59% respectively.  The weightedaverage rate of our certificates of deposit was 3.82% compared to 1.77% for thesavings products.

 

Deposit interest rates decreased throughout 2008 following the ratereductions by the Federal Reserve Board. On an average basis, interest bearing deposits increased $11.9 millionwhile the average rates paid on all interest bearing deposits decreased by 82basis points and on all interest bearing liabilities by 86 basis points.  Throughout 2008 deposit growth was achievedin our Oroville, Central Chico, North Paradise, Marysville, Colusa, Corning,Redding and Anderson branches.

 

###### **Loan Portfolio**

######  

The Company offers a wide variety of loan types and terms to customersalong with very competitive pricing and quick delivery of the credit decision.The Company’s loan portfolio represents the single largest portion of investedassets, substantially greater than the investment portfolio or any other assetcategory. At December 31, 2008, gross loans represented 83.1% of totalassets, as compared to 77.1% and 81.5% at December 31, 2007 and 2006,respectively. The Company’s total loans declined in the fourth quarter of 2008by $17.4 million from the September 30, 2008, balances as severalcustomers paid their loans off. The quality and diversification of the Company’sloan portfolio are important considerations when reviewing the Company’sresults of operations.

 

38

----

Table of Contents

 

The Selected Financial Data table in Item 6 reflects the net amount ofloans outstanding at December 31st for each year between 2004 and 2008. The LoanDistribution table which follows sets forth the amount and composition of theCompany’s total loans outstanding in each category at the dates indicated.

 

**LoanDistribution**

(dollars in thousands)

 
| ** **                    | ** ** | **December 31,** | ** ** |
|-------------------------------|------------|-----------------------|------------|
| **(dollars in thousands)**    | ** ** | **2008**              | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| Agriculture                   |       | $                     | 28,628     |   | $ | 26,347 |   | $ | 25,745 |   | $ | 24,803 |   | $ | 22,177 |   |
| Commercial                    |       | 83,786                |       | 78,521 |   | 65,241 |   | 61,162 |   | 58,662 |   |
| Real estate- commercial       |       | 252,018               |       | 207,590 |   | 208,102 |   | 173,449 |   | 146,876 |   |
| Real estate- construction     |       | 65,004                |       | 81,914 |   | 105,449 |   | 111,130 |   | 90,643 |   |
| Installment                   |       | 65,390                |       | 52,898 |   | 43,789 |   | 36,501 |   | 26,219 |   |
|                          |       | 494,826               |       | 447,270 |   | 448,326 |   | 407,045 |   | 344,577 |   |
|                          |       |                  |       |   |   |   |   |   |   |   |   |
| Deferred loan fees, net       |       | (478                  | )          | (688 | ) | (801 | ) | (1,108 | ) | (1,022 | ) |
| Allowance for loan losses     |       | (7,826                | )          | (5,232 | ) | (5,274 | ) | (4,716 | ) | (4,381 | ) |
|                          |       | $                     | 486,522    |   | $ | 441,350 |   | $ | 442,251 |   | $ | 401,221 |   | $ | 339,174 |   |
|                          |       |                  |       |   |   |   |   |   |   |   |   |
| **Percentage of Total Loans** |       |                  |       |   |   |   |   |   |   |   |   |
| Agriculture                   |       | 5.79                  | %          | 5.89 | % | 5.74 | % | 6.09 | % | 6.44 | % |
| Commercial                    |       | 16.93                 | %          | 17.56 | % | 14.55 | % | 15.03 | % | 17.02 | % |
| Real estate- commercial       |       | 50.93                 | %          | 46.41 | % | 46.42 | % | 42.61 | % | 42.63 | % |
| Real estate- construction     |       | 13.14                 | %          | 18.31 | % | 23.52 | % | 27.30 | % | 26.31 | % |
| Installment                   |       | 13.21                 | %          | 11.83 | % | 9.77 | % | 8.90 | % | 7.61 | % |
|                          |       | 100.00                | %          | 100.00 | % | 100.00 | % | 100.00 | % | 100.00 | % |

 

As reflected in the Loan Distribution table, the net loan balances haveincreased $147 million, or 43%, over the last four years. The largestpercentage of growth over that four year period and continuing in 2008 was ininstallment loans which grew by $12 million in 2008 and 149% over the past fouryears.  The largest dollar volumeincrease during that four year period was in commercial real estate which grewby $105.1 million or 72%.  Reflective ofthe current economy and the residential real estate markets, real estateconstruction loans decreased in 2008 continuing the trend beginning in 2006.

 

Loan growth in the Company’s immediate market has been oriented towardloans secured by real estate, commercial loans, including Small BusinessAdministration loans, as well as installment loans. As a result, these areashave comprised the major portion of the Company’s loan growth over the past fewyears. During 2008 loans secured by real estate declined by $24 million, or7.7%, and commercial loans grew by $5.2 million, or 6.7%.  Installment loans increased by $12 million,or 23.6%.  Loans secured by real estateand commercial loans comprised 64.1% and 16.9%, respectively, of the Bank’stotal loan portfolio at December 31, 2008.

 

The Company’s commercial loans are centered in locally orientedcommercial activities in the markets where the Company has a presence.Additionally, the Company has a Government Lending Division dedicated to itsSBA product and its Business and Industry (B&I) Guaranteed Loan Program.The Company was recognized as the fourth largest USDA Business and Industry(B&I) Lender in the nation during 2008 based on the origination of nineteenloans totaling more than $38 million. The Company is also designated as an SBA Preferred Lender, which meansit has the authority to underwrite and approve SBA loans locally. Thisrecognition lends credence to the Company’s success in meeting the needs ofsmaller business owners in the communities in which the Company conducts itsbanking activities.

 

The most significant shift in the loan portfolio mix over the past fouryears has been in loans secured by real estate construction, which decreasedfrom 26.3% of total loans at the end of 2004 to 13.1% of total loans at the endof 2008. Real estate lending continues to be an important part of the Company’sfocus, and even though this segment of loans has decreased since 2006 and islikely to continue to decrease in the future due to current economicconditions. Commercial loans remained consistent at 16.9% of total loanbalances at the end of 2008 compared to 17.0% at the end of 2004, andagricultural loans decreased during the same period to 5.8% of the total loanbalances from 6.4%. The decline in the percentage of agricultural loans to totalloans over the last few years has been due to the growth in the other lendingareas outpacing the growth in the agricultural lending. Agricultural borrowingrelationships have remained consistent year after year and we have notsubstantially expanded this part of our business.  Installment loans have increased from 7.6% ofthe portfolio in 2004 to 13% of total loans at the end of 2008.

 

39

----

Table of Contents

 

Another important aspect of the Company’s loan business is related toresidential real estate loans which were generated internally by the realestate mortgage loan department and then sold in the secondary market togovernment sponsored enterprises or other long-term lenders. The Company hasconsistently been among the largest real estate mortgage lenders in ButteCounty for the past several years. Reflective of the current real estatemarket, during 2008, the Company originated and sold aggregate balances ofapproximately $12 million of such loans, a $27 million decrease from the $39million originated and sold in 2007.

 

In the normal course of business, the Company makes commitments toextend credit as long as there are no violations of any condition establishedin the contractual arrangement. Total outstanding commitments to extend creditwere $148 million at December 31, 2008 as compared to $184 million at December 31,2007. These commitments represented 30% and 41% of outstanding gross loans at December 31,2008 and December 31, 2007, respectively. The Company’s stand-by lettersof credit at December 31, 2008 were $6.5 million and $6.7 million at December 31,2007, respectively, which represented approximately 4.4% and 3.5% of totalcommitments outstanding at the end of 2008 and 2007. It is not anticipated thatall of these commitments or stand-by letters of credit will fund.

 

Approximately one half of the loans held by the Company have floatingrates of interest tied to the Company’s base lending rate or to another marketrate indicator so that they may be re-priced as interest rates change.  In periods of falling interest rates,especially when rates on floating rate loans decline the Company hasestablished interest rate floors under some of its loans so that no matter howfar loan rates fall, it is guaranteed a minimum rate of return.

 

The same interest rate and liquidity risks that apply to securities arealso applicable to lending activity. Fixed-rate loans are subject to marketrisk:  they decline in value as interestrates rise. The Company’s loans that have fixed rates generally have relativelyshort maturities or amortize monthly, which effectively lessens the marketrisk. The table in Note 16 to the consolidated financial statements In Item 8shows that at December 31, 2008, the difference in the carrying amount ofloans, i.e., their face value, is about $ 1.1 million or .22 % less than theirfair value. At the end of 2007, the carrying amount of loans was about $3.3 millionor .75% more than the fair value.

 

Because the Company is not involved with chemicals or toxins that mighthave an adverse effect on the environment, its primary exposure toenvironmental legislation is through its lending activities. The Company’s lendingprocedures include steps to identify and monitor this exposure to avoid anysignificant loss or liability related to environmental regulations.

 

**Loan Maturities**

 

The following Loan Maturity table shows the amounts of total loansoutstanding as of December 31, 2008, which, based on remaining scheduledrepayments of principal, are due within one year, after one year but less thanfive years, and in more than five years. (Non-accrual loans are intermixedwithin each category.)

 
| **(dollars in thousands)** | ** ** | **One year   or less** | ** ** | **One to five   years** | ** ** | **Over five   years** | ** ** | **Total** | ** ** | **Floating rate:   due after one   year** | ** ** | **Fixed rate:   due after   one year** | ** ** |
|----------------------------|------------|---------------------------------------|------------|----------------------------------------|------------|---------------------------------|------------|-----------|------------|--------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
| Agricultural               |       | $                                     | 15,773     |                                   | $          | 11,708                          |       | $         | 1,147      |                                                               | $          | 28,628                                                          |       | $ | — |   | $ | 12,855 |   |
| Commercial                 |       | 24,805                                |       | 13,199                                 |       | 45,782                          |       | 83,786    |       | 12,404                                                             |       | 46,577                                                          |       |
| Real estate - commercial   |       | 144,402                               |       | 87,132                                 |       | 20,484                          |       | 252,018   |       | 3,633                                                              |       | 103,983                                                         |       |
| Real estate - construction |       | 60,270                                |       | 4,734                                  |       | —                          |       | 65,004    |       | —                                                             |       | 4,734                                                           |       |
| Installment                |       | 8,599                                 |       | 36,650                                 |       | 20,141                          |       | 65,390    |       | —                                                             |       | 56,791                                                          |       |
|                       |       |                                  |       |                                   |       |                            |       |      |       |                                                               |       |                                                            |       |   |   |   |   |   |   |
| Total                      |       | $                                     | 253,849    |                                   | $          | 153,423                         |       | $         | 87,554     |                                                               | $          | 494,826                                                         |       | $ | 16,037 |   | $ | 224,940 |   |

 

40

----

Table of Contents

 

This schedule, which aggregates contractualprincipal repayments by time period, can be used in combination with theInvestment Maturities table in the Investment Securities section and theDeposit Maturities table in the Deposits section to identify time periods withpotential liquidity exposure. The referenced maturity schedules do not convey acomplete picture of the Company’s re-pricing exposure or interest rate risk,however. For details on the re-pricing characteristics of the Company’s balancesheet and a more comprehensive discussion of the Company’s sensitivity tochanges in interest rates, see the “Liquidity and Market Risk” section.

 

###### **Non-performing Assets**

######  

Banks have generally suffered their most severe earnings declines as aresult of customers’ inability to generate sufficient cash flow to servicetheir debts, or as a result of the downturns in national and regional economieswhich have brought about declines in overall property values. In addition,certain investments which the Company may purchase have the potential of becomingless valuable as the conditions change in the obligor’s financial capacity torepay, based on regional economies or industry downturns. As a result of thesetypes of failures, an institution may suffer asset quality risk, and may losethe ability to obtain full repayment of an obligation to the Company. Sinceloans are the most significant assets of the Company and generate the largestportion of revenues, the Company’s management of asset quality risk is focusedprimarily on loan quality.

 

The Company achieves a certain level of loan quality by establishing asound credit plan, which includes defining goals and objectives and devisingand documenting credit policies and procedures. These policies and proceduresidentify certain markets, set goals for portfolio growth or contraction, andestablish limits on industry and geographic concentrations. In addition, thesepolicies establish the Company’s underwriting standards and the methods ofmonitoring ongoing credit quality. Unfortunately, however, the Company’sasset-quality risk may be affected by external factors such as the level ofinterest rates, employment, general economic conditions, real estate values andtrends in particular industries or certain geographic markets. The Company’sinternal factors for controlling risk are centered in underwriting practices,credit granting procedures, training, risk management techniques, andfamiliarity with our loan customers as well as the relative diversity andgeographic concentration of our loan portfolio.

 

From time to time, Management has reason to believe that certainborrowers may not be able to repay their loans within the parameters of thepresent repayment term, even though, in some cases, the loans are current atthe time. These loans are regarded as potential problem loans, and a portion ofthe allowance is assigned and/or allocated, as discussed below, to cover theCompany’s exposure to loss would the borrowers indeed fail to perform accordingto the terms of the notes. This class of loans is in addition to the loans in anonaccrual status or 90 days or more delinquent but still accruing, which areshown in the table below.

 

As a multi-community, independent bank headquartered in and servingButte County (with a smaller presence in each of Colusa, Sutter, Sacramento,Shasta, Tehama, and Yuba counties); the Company has mitigated its risk to anyone segment of these Northern Sacramento Valley markets. The Company’s assetquality has been a strength for many years but due to the current economicdownturn, the level of non performing loans and assets, and loan delinquencyratios have increased significantly. The Company is diligently working withborrowers that are having difficulty meeting their contractual obligations.

 

Non-performing assets are comprised of loans on non-accrual status,loans 90 days or more past due and still accruing interest, loans restructuredwhere the terms of repayment have been renegotiated resulting in a deferral ofinterest or principal and other real estate (“ORE”). Loans are generally placedon non-accrual status when they become 90 days past due as to principal orinterest. Loans may be restructured by management when a borrower hasexperienced some change in financial status causing an inability to meet theoriginal repayment terms and where the Company believes the borrower willeventually overcome those circumstances and repay the loan in full. OREconsists of properties acquired by foreclosure or similar means that managementintends to offer for sale.

 

The Bank considers a loan or lease impaired if, based on currentinformation and events, it is probable that the company will be unable tocollect the scheduled payments of principal or interest when due according tothe contractual terms of the loan agreement. The measurement of impaired loans and leases is generally based on thepresent value of expected future cash flows discounted at the historicaleffective interest rate, except that all collateral-dependent loans and leasesare measured for impairment based on the fair value of the collateral lessselling costs.

 

41

----

Table of Contents

 

Management’s classification of a loan as non-accrual is an indicationthat there is reasonable doubt as to the full collectibility of principal orinterest on the loan; at that point, the Company stops recognizing income fromthe interest on the loan and reverses any uncollected interest that had beenaccrued but unpaid. These loans may or may not be collateralized, butcollection efforts are continuously pursued.

 

The following table provides information with respect to components ofthe Company’s non-performing assets at the date indicated. The Company has nothad any loans 90 days past due and still accruing interest in any periodspresented.

 

**Non-performing Assets**

(dollars in thousands)

 
| ** **                                                               | ** ** | **As of December 31,** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                               | ** ** | **2008**                              | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Nonaccrual Loans:**                                                    |       |                                  |       |   |   |   |   |   |   |   |   |
| Agricultural                                                             |       | $                                     | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | 17 |   |
| Commercial and Industrial                                                |       | $                                     | 395        |   | $ | — |   | $ | 1,502 |   | $ | — |   | $ | — |   |
| **Real Estate**                                                          |       |                                  |       |   |   |   |   |   |   |   |   |
| Secured by Commercial/Professional Office                                |       | $                                     | 2,721      |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Properties Including Construction and  Development                       |       | $                                     | 9,061      |   | $ | 233 |   | $ | — |   | $ | — |   | $ | — |   |
| Secured by Residential Properties                                        |       | $                                     | 2,708      |   | $ | 20 |   | $ | 780 |   | $ | — |   | $ | 84 |   |
| Secured by Farmland                                                      |       | $                                     | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Consumer Loans                                                           |       | $                                     | —     |   | $ | — |   | $ | — |   | $ | 9 |   | $ | — |   |
| **SUBTOTAL**                                                             |       | $                                     | 14,885     |   | $ | 253 |   | $ | 2,282 |   | $ | 9 |   | $ | 101 |   |
|                                                                     |       |                                  |       |   |   |   |   |   |   |   |   |
| Other Real Estate (ORE)                                                  |       | $                                     | 2,068      |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Total non-performing Assets                                              |       | $                                     | 16,953     |   | $ | 253 |   | $ | 2,282 |   | $ | 9 |   | $ | 101 |   |
| Restructured Loans                                                       |       | $                                     | 11,407     |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Non-performing loans as % of total gross  loans                          |       | 3.01                                  | %          | 0.06 | % | 0.51 | % | 0.00 | % | 0.03 | % |
| Non-performing assets as a % of total gross  loans and other real estate |       | 3.41                                  | %          | 0.06 | % | 0.51 | % | 0.00 | % | 0.03 | % |

 

**Impaired, Nonaccrual, Past Due and Restructured Loans and Leased andOther Nonperforming Assets:**

 

Total non-performing assets were $16,953,000 at the end of 2008, whichconsisted of thirty-two loans for a total of $14,885,000 classified as impairedand on as non-accrual and ten properties for a total of $2,068,000 classifiedas Other Real Estate.  Twenty of theloans in non-accrual status were secured by 1-4 family residential constructionor land development for a total of $9,061,000. Six of the non-accrual loanswere secured by first deeds of trust on 1-4 family residential properties for atotal of $2,708,000.  Two of thenon-accrual loans were secured by owner occupied non residential properties fora total of $2,721,000.  Four of thenon-accrual loans were classified commercial and industrial for a total of$395,000.  Other than the loans includedas non-performing assets at December 31, 2007, the company has notidentified any potential problem loans that would result in any loan beingincluded as a non-performing assets at a future date.

 

Non-performing loans (defined as nonaccrual loans and loans 90 days ormore past due and still accruing interest) totaled $14,885,000 at December 31,2008, an increase $14,632,000 from the total at December 31, 2007.  Nonperforming loans as a percentage of totalloans were 3.1% at December 31, 2008 compared to 0.06% at December 31,2007.

 

Nonperforming assets, (Nonperforming loans and ORE) total $16,953,000at December 31, 2008, an increase of $16,700,000 from December 31,2007.  Nonperforming assets as apercentage of total assets were 2.85% at December 31, 2008 compared to0.00% at December 31, 2007.

 

Restructured loans were $11,407,000 at December 31, 2008 comparedto having no restructured loans at December 31, 2007.  Restructured loans consist of one singlefamily residence for $205,000.  Therewere five land/development loans for a total of $8,117,000. One of these loansis considered impaired in the amount of $589,000 and is included as part of thenon-performing loans.  Two of these loansare construction loans for the construction of individual homes and total$2,548,000. The last two loans are commercial real estate loans totaling$536,000.  Both of these loans representthe unguaranteed portion of USDA loans and have guarantees under thisprogram.  One of these loans is includedas part of the non-performing loans and is on non-accrual.  This loan totals $399,000 and has a specificreserve of $111,000.  Except for theloans mentioned above, the remaining restructured loans are performing asagreed and were all current at December 31, 2008.

 

42

----

Table of Contents

 

The most significant increase in both non-performing loans and assetsoccurred in the fourth quarter of 2008. The level of non-performing loans increased $6,694,000 to $14,885,000 atDecember 31, 2008 from $8,191,000 at September 30, 2008 primarily asa result of increasing problem loans mainly in the Company’s realestate/development portfolio.  Specificreserves on the non-performing loans of $1,156,000 have been recorded at December 31,2008.  Non-performing assets increased$7,468,000 to $17,119,000 at December 31, 2008 from $9,651,000 at September 30,2008.  Set forth below is a discussion ofour significant non-performing assets:

 

The largest of the nonperforming loans consist of two development loansto the same borrower for a total of $3,032,000 which was included in ourclassified loans and risk rated substandard at December 31, 2008 based onslow sales and a weakening real estate market. The project has only shown two lot sales in the past 12 months, both ofwhich were in January 2008.  Theproject consists of 46 finished lots and 61 paper lots.  To identify the Company’s potential lossexposure and properly value the collateral support provided by the propertywith the continuing decline in real estate values in California, a newappraisal was ordered in September 2008 and received on October 8,2008.  The appraisal demonstrated thecontinuing declined in the value of the underlying project.  In November 2008 the borrower notifiedthe Company that he intended to relinquish the properties and foreclosure wasstarted November 3, 2008.  The loanswere placed on non-accrual on November 3, 2008 and all previously accruedbut unpaid interest was reversed.  As of December 31,2008 the loan for the 46 finished lots totaled $2,270,000 and the Companyallocated a specific reserve of $235,000 on this loan based on an impairedanalysis performed on December 31, 2008. The October appraised value for the 61 paper lots was $945,000compared to the December 31, 2008 balance of $762,000, resulting in loanto value (LTV) of 81%.  As this providesthe Company with an adequate margin, no specific reserves were allocated tothis loan.

 

Another nonperforming loan was originally made for the construction ofa car wash and lube operation in Woodland, California for $2,006,000.  This loan was included in our classifiedloans and risk rated substandard at December 31, 2008 due to lack ofsales. This loan is a government guaranteed loan under the USDA program with an80% guarantee and a maximum exposure to the Company of $401,000.  During the fall of 2008, the borrower waslate on two payments and informed the Company that he was having cash flow problems.  The Company met with the borrower and in October 2008the borrower notified the Company that he would not be making any morepayments.  The loan was placed onnon-accrual and the Company started foreclosure on November 3, 2008.  To identify the Company’s potential lossexposure and properly value the collateral support provided by the property anew appraisal was ordered in October 2008 and received on November 27,2008.  This new appraisal reflects thedownturn in real estate values as it was significantly lower than the originalappraisal.  The company submitted aliquidation plan to the USDA which was approved and the property was placed inother real estate (ORE) on March 4, 2009. On March 13, 2009 the bankreceived funds from the UDSA paying this loan down to the unguaranteed loanamount of $401,000.  The Companyallocated a specific reserve of $111,000 for this loan on December 31,2008 after performing an impaired analysis. The Company had no additional write-downs when this loan was transferredto ORE on March 4, 2009.

 

Another development loan (for $1,643,000 - at December 31, 2008)was included in our classified listing and risk rated substandard.  This loan represents a 37% participatedinterest in a loan from another bank. The project consists of 46 lots of an original 49 lot subdivisionlocated in Nevada County, California.  OnDecember 2, 2008 the participating bank met with the borrower and wasinformed by the borrower that he would no longer be able to make the loanpayments.  This decision was due to theslower sales and continued weak real estate market.  On December 8, 2008 the Company placedthis loan on non-accrual.  To identifythe Company’s potential loss exposure and properly value the collateral supportprovided by the property a new appraisal was ordered and received on December 10,2008.  This new appraisal reflects thedownturn in the real estate values and demonstrated the continuing decline inthe value of the underlying project.  Thenew appraisal for the entire project supported a value of $4,400,000 of whichour 37% interests represents approximately $1,628,000 resulting in a LTV ofapproximately 100%.  As of December 31,2008 the Company had established a specific reserve of $33,000 for thisloan.  On February 17, 2009 theCompany recorded a Deed in Lieu of Foreclosure. After the foreclosure was completed the Bank charged-off an additional$167,000 against the allowance for loan losses in February 2009 upontransfer to ORE.

 

Another development loan for the construction an eight unit condominiumproject in the Yuba City area for $1,646,000 was included in our classifiedloans and risk rated Substandard at December 31, 2008 based on the lack ofcash flow and weakening real estate market. Construction of the project is complete and as of December 31, 2008five units have been leased.  In June of2008, the Company received an updated appraisal on the units and found theestimated fair value of the collateral to be below the carrying amount of theloan balance.  The Company met with theborrower and requested additional collateral which the borrower was unable toprovide.  All payments were paid asagreed until October 2008.  In November of2008, the borrower notified the Company that they would no longer be able tomake the payments.  The loan was placedon non-accrual December 30 2008. Due to the continued decline in the real estate market, the Companyordered another appraisal to understand the potential loss exposure andproperly value the collateral.  A newappraisal was received in December 2008 with an appraised value for the 8units of $1,050,000.  At December 31,2008 this loan is being reviewed by our attorney for possible legal actionagainst the borrower.  At December 31,2008 the Company had established a specific reserve of $660,000 for this loan.On March 18, 2009 a charge-off of $500,000 against the allowance for loanlosses was recorded.

 

43

----

Table of Contents

 

The last significant non performing loan is a residential developmentlocated in Redding area for $874,000 which was included in our classified loansand risk rated Substandard at December 31, 2008 based on slower sales andweakening real estate market.  The loanhad eight homes sales close in 2007 but no sales of the remaining 3 homes or 2lots in 2008.  The Company met with theborrower in August of 2008 and discussed the status of the project andreceived additional collateral.  Inreturn the Company deferred the interest payments on the loan for 6months.  The loan was placed onnon-accrual on August 26, 2008.  Tounderstand the potential loss exposure and properly value the collateral withthe continuing decline in the real estate values in California, a new appraisalwas ordered on the project in August 2008 and received in September of2008.  The appraisal demonstrated thecontinuing decline of the values underlying the project.  The September appraisal of the 3 homesand 2 lots was $1,025,000.  No sales haveoccurred since December 2007.  Dueto the deferral on interest and higher loan to value, the Company considersthis loan impaired but as this provides the Company with an adequate margin, nospecific reserves were allocated to this loan.

 

The remainder of the non-performing assets includes 13 SFR lots thatcurrently total $1,246,866 and are in ORE. The amounts placed in ORE are supported by current appraisals receivedby the Company all within the past 7 months. In addition, there are threesingle family homes that are included in ORE at December 31, 2008 with acombined balance of $416,624 and supported by current appraisals totaling$635,000.  When loans are placed intoORE, the Company determines the fair market value less the estimated sellingcosts.  The shortfalls are charged to theallowance for loan losses at the time of transfer.  Properties placed in ORE are reviewedcontinuously and the Company will reappraise the property if it is deemednecessary.  At a minimum, properties areappraised at least annually. If values have dropped, the Company will establisha valuation allowance for the ORE through a separate provision for losses onORE.

 

The remainder of the non-performing loans consists primarily of twelveimpaired single family homes that total $1,651,000 of which four homes arecurrently under construction, eleven impaired lot loans that total $1,910,000and one commercial real estate loan for $656,000.  The commercial real estate loan was takeninto ORE in February 2009 with no additional charge to the allowance forloan losses.  These loans are locatedthroughout Northern California from Sacramento to Redding and the currentappraised values provide the Company with an adequate margin and no specificreserves were allocated to the loans.

 

###### **Allowancefor Loan Losses**

######  

The allowance for loan losses is established through a provision forloan losses based on management’s evaluation of known and inherit risk in ourloan portfolio. The allowance is increased by provisions charged againstcurrent earnings and reduced by net charge-offs. Loans are charged off whenthey are deemed to be uncollectible; recoveries are generally recorded onlywhen cash payments are received subsequent to the charge off. The followingtable summarizes the activity in the allowance for loan losses for the pastfive years.

 

44

----

Table of Contents

 

**Allowance for Loan Losses**

(In thousands, except for percentages)

 
| ** **                                                      | ** ** | **As of December 31,** | ** ** |
|-----------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                      | ** ** | **2008**                              | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Balances:**                                                   |       |                                  |       |   |   |   |   |   |   |   |   |
| Average loans outstanding during period                         |       | $                                     | 482,208    |   | $ | 456,818 |   | $ | 445,119 |   | $ | 382,659 |   | $ | 313,912 |   |
| Gross loans outstanding at end of period.                       |       | $                                     | 494,826    |   | $ | 447,270 |   | $ | 448,326 |   | $ | 407,045 |   | $ | 344,577 |   |
|                                                            |       |                                  |       |   |   |   |   |   |   |   |   |
| **Allowance for Loan Losses:**                                  |       |                                  |       |   |   |   |   |   |   |   |   |
| Allowance for possible loan losses at  beginning of period      |       | $                                     | 5,232      |   | $ | 5,274 |   | $ | 4,716 |   | $ | 4,000 |   | $ | 3,587 |   |
| Adjustments                                                     |       | $                                     | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Provision charged to expense                                    |       | $                                     | 3,175      |   | $ | 225 |   | $ | 775 |   | $ | 824 |   | $ | 790 |   |
|                                                            |       |                                  |       |   |   |   |   |   |   |   |   |
| Loans charge-offs                                               |       |                                  |       |   |   |   |   |   |   |   |   |
| Agricultural                                                    |       | $                                     | —     |   | $ | 2 |   | $ | — |   | $ | — |   | $ | — |   |
| Commercial & industrial loans                          |       | $                                     | 71         |   | $ | 13 |   | $ | 42 |   | $ | — |   | $ | 11 |   |
| Real estate                                                     |       | $                                     | 1,046      |   | $ | 8 |   | $ | 31 |   | $ | — |   | $ | — |   |
| Consumer                                                        |       | $                                     | 41         |   | $ | 3 |   | $ | 9 |   | $ | 9 |   | $ | 12 |   |
| Credit card loans                                               |       | $                                     | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Total                                                           |       | $                                     | 1,158      |   | $ | 26 |   | $ | 82 |   | $ | 9 |   | $ | 23 |   |
|                                                            |       |                                  |       |   |   |   |   |   |   |   |   |
| Recoveries                                                      |       |                                  |       |   |   |   |   |   |   |   |   |
| Agricultural                                                    |       | $                                     | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Commercial                                                      |       | $                                     | 2          |   | $ | — |   | $ | 2 |   | $ | 1 |   | $ | 15 |   |
| Real estate                                                     |       | $                                     | 5          |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Consumer                                                        |       | $                                     | 3          |   | $ | — |   | $ | — |   | $ | — |   | $ | 12 |   |
| Credit card loans                                               |       | $                                     | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Total                                                           |       | $                                     | 10         |   | $ | — |   | $ | 2 |   | $ | 1 |   | $ | 27 |   |
| Net loan charge-offs                                            |       | $                                     | 1,148      |   | $ | 26 |   | $ | 80 |   | $ | 8 |   | $ | (4 | ) |
| Allowance for unfunded loan commitments                         |       | $                                     | 567        |   | $ | (241 | ) | $ | (137 | ) | $ | (100 | ) | $ | (381 | ) |
| Allowance for loan losses at end of period                      |       | $                                     | 7,826      |   | $ | 5,232 |   | $ | 5,274 |   | $ | 4,716 |   | $ | 4,000 |   |
|                                                            |       |                                  |       |   |   |   |   |   |   |   |   |
| **Ratios:**                                                     |       |                                  |       |   |   |   |   |   |   |   |   |
| Net loan charge-offs to average loans                           |       | 0.24                                  | %          | 0.00 | % | 0.02 | % | 0.00 | % | 0.00 | % |
| Allowance for loan losses to gross loans at  end of period      |       | 1.58                                  | %          | 1.17 | % | 1.18 | % | 1.16 | % | 1.16 | % |
| Allowance for loan losses to non-performing  loans              |       | 52.58                                 | %          | 2067.98 | % | 52411.11 | % | 52400.00 | % | 3960.40 | % |
| Net charge-offs to allowance for loan  losses at end of period  |       | 14.67                                 | %          | 0.50 | % | 1.52 | % | 0.17 | % | (0.10 | )% |
| Net loan charge-offs to provision charged  to operating expense |       | 36.16                                 | %          | 11.56 | % | 10.32 | % | 0.97 | % | (0.51 | )% |

 

We employ a systematic methodology for determining the allowance forloan losses that includes a monthly review process and monthly adjustment ofthe allowance. Our process includes a periodic review of individual loans thathave been specifically identified as problem loans or have characteristicswhich could lead to impairment, as well as detailed reviews of other loans(either individually or in pools). While this methodology utilizes historicaland other objective information, the establishment of the allowance for loanlosses and the classification of loans are, to some extent, based on management’sjudgment and experience.

 

Our methodology incorporates a variety of risk considerations, bothquantitative and qualitative, in establishing an allowance for loan losses thatmanagement believes is appropriate at each reporting date. Quantitative factorsinclude our historical loss experience, delinquency and charge-off trends,collateral values, changes in non-performing loans, and other factors.Quantitative factors also incorporate known information about individual loans,including borrowers’ sensitivity to interest rate movements and borrowers’sensitivity to quantifiable external factors including commodity prices as wellas acts of nature (freezes, earthquakes, fires, etc.) that occur in aparticular period.

 

45

----

Table of Contents

 

Qualitative factors include the general economic environment inNorthern California and, in particular, in our markets wherein we monitor thestate of the agriculture industry and other key industries in the NorthernSacramento Valley. The way a particular loan might be structured, the extentand nature of waivers of existing loan policies, loan concentrations and therate of portfolio growth are other qualitative factors that are considered.

 

Our methodology is, and has been, consistently followed. However, as weadd new products, increase in complexity, and expand our geographic coverage,we expect to enhance our methodology to keep pace with the size and complexityof the loan portfolio. On an ongoing basis we engage outside firms toindependently assess our methodology, and to perform independent credit reviewsof our loan portfolio. The FDIC and the California Department of FinancialInstitutions review the allowance for loan losses as an integral part of theexamination processes. Management believes that our current methodology isappropriate given our size and level of complexity. Further, management believesthat the allowance for loan losses is adequate as of December 31, 2008 tocover known and inherent risks in the loan portfolio. However, fluctuations incredit quality, or changes in economic conditions or other factors could causemanagement to increase or decrease the allowance for loan losses as necessary.

 

The following table provides a summary of the allocation of theallowance for loan losses for specific loan categories at the dates indicated.The allocation presented should not be interpreted as an indication thatcharges to the allowance for loan losses will be incurred in these amounts orproportions, or that the portion of the allowance allocated to each loancategory represents the total amounts available for charge-offs that may occurwithin these categories. The unallocated portion of the allowance for loanlosses and the total allowance is applicable to the entire loan portfolio.

 

**Allocationof Loan Loss Allowance**

(dollars in thousands)

 
| ** **                        | ** ** | **As of December 31,** | ** ** |
|-----------------------------------|------------|---------------------------------------|------------|
| ** **                        | ** ** | **2008**                              | ** ** | **2007** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                        | ** ** | ** **                            | ** ** | **% Total (1)** | ** ** | ** ** | ** ** | **% Total (1)** | ** ** | ** ** | ** ** | **% Total (1)** | ** ** | ** ** | ** ** | **% Total (1)** | ** ** | ** ** | ** ** | **% Total (1)** | ** ** |
| ** **                        | ** ** | **Amount**                            | ** ** | **Loans** | ** ** | **Amount** | ** ** | **Loans** | ** ** | **Amount** | ** ** | **Loans** | ** ** | **Amount** | ** ** | **Loans** | ** ** | **Amount** | ** ** | **Loans** | ** ** |
| Agricultural                      |       | $                                     | 94         |   | 1.16 | % | $ | 313 |   | 5.89 | % | $ | 219 |   | 5.74 | % | $ | 200 |   | 6.09 | % | $ | 244 |   | 6.44 | % |
| Commercial                        |       | $                                     | 1,037      |   | 12.77 | % | $ | 631 |   | 16.13 | % | $ | 626 |   | 14.55 | % | $ | 1,123 |   | 15.03 | % | $ | 690 |   | 17.02 | % |
| Real Estate                       |       | $                                     | 6,510      |   | 80.19 | % | $ | 4,628 |   | 65.95 | % | $ | 4,172 |   | 69.94 | % | $ | 3,488 |   | 69.91 | % | $ | 3,027 |   | 68.93 | % |
| Installment Loans                 |       | $                                     | 477        |   | 5.88 | % | $ | 520 |   | 12.03 | % | $ | 876 |   | 9.77 | % | $ | 386 |   | 8.97 | % | $ | 420 |   | 7.61 | % |
| Reserve for  Unfunded Commitments |       | $                                     | (293       | ) |   |   | $ | (860 | ) |   |   | $ | (619 | ) |   |   | $ | (481 | ) |   |   | $ | (381 | ) |   |   |
| **TOTAL**                         |       | $                                     | 7,826      |   | 100.00 | % | $ | 5,232 |   | 100.00 | % | $ | 5,274 |   | 100.00 | % | $ | 4,716 |   | 100.00 | % | $ | 4,381 |   | 100.00 | % |

 

----

(1) Representspercentage of loans in category to total loans.

 

At December 31,2008, the Company’s allowance for loan losses was $7.8 million. The loan lossand undisbursed commitment provisions in 2008, 2007, and 2006 totaled$3,175,000, $225,000, and $775,000, respectively. Over the past five years, netcharge-offs have averaged $258,000. The Company ended 2008 with net loan lossesof $1,148,000, compared to net losses of $26,000 during 2007.  A total of $961,000 in losses during 2008were partial write downs due to decreasing appraised values.

 

**Other LoanPortfolio Information**

 

Loan Concentrations:  The concentration profile of the Company’sloans is discussed in Note 10 to the accompanying Consolidated FinancialStatements.

 

Loan Sales and Servicing Rights:  The Company sells or brokers some of theloans it originates through the SBA and FMHA B&I programs. Some of theloans are sold “servicing released” and the purchaser takes over the collectionof the payments. However, some are sold with “servicing retained” and theCompany continues to receive the payments from the borrower and forwards thefunds to the purchaser. The Company earns a fee for this service. The sales aremade without recourse, that is, the purchaser cannot look to the Company in theevent the borrower does not perform according to the terms of the note. Whenloans are sold, a portion of the sale is attributed to the right to receive thefee for servicing and this value is recorded as a separate servicing asset.Servicing rights are amortized over the expected term of the related servicingincome.  At December 31, 2007 and2006, the amortized cost of these assets was $2,004,000 and $1,104,000respectively.

 

46

----

Table of Contents

 

###### **Investment Portfolio**

######  

The investment securities portfolio had a carrying value of $7.1million at December 31, 2008. The Company classified its investments intotwo categories: “held-to-maturity”, and “available-for-sale”. The Company doesnot have any investments classified as trading. The held-to-maturity portfolioconsists only of investments that the Company has both the intention andability to hold until maturity, to be sold only in the event of concerns withan issuer’s creditworthiness, a change in tax law that eliminates their taxexempt status or other infrequent situations as permitted under GAAP. Given thesmall and non complex nature of the portfolio, management does not rely heavilyon these investments as a source of funds for growth in the loan portfolio.

 

Securities pledged as collateral on repurchase agreements, publicdeposits and for other purposes as required or permitted by law were $4,356,000as of December 31, 2008 and $4,360,000 as of December 31, 2007.

 

The total investment portfolio increased to $7.1 million as of December 31,2008 from $6.3 million at December 31, 2007. The Company’s investmentportfolio is composed primarily of:  (1) U.S.Treasury and Agency issues for liquidity and pledging; and (2) state,county and municipal obligations which provide tax free income and pledgingpotential. The distribution of these groups within the overall portfolioremained relatively consistent.   TheU.S. Treasury and Agency issues continue to be the largest portion of the totalportfolio at 77%, down from 78% at the end of 2007. Municipal issues comprised19% of total investments at the end of 2008, down from 22% at the end of 2007.

 

During its assessment of the investmentportfolio for other-than-temporary impairment of investment securities,management considers many factors.  Incases where a security is of a type for which there is very little activetrading, if any, management must consider other factors when conducting itsevaluation.  As of December 31,2008, the Company held one such security, a trust preferred security.  Although all scheduled interest payments havebeen received through December 31, 2008, management considered otherfactors and made certain assumptions in reaching its conclusion.  Such factors and assumptions includedindependent indications of the fair value of the security, adverse conditionsrelated to the financial industry in general, the financial condition of theissuer, and certain assumptions regarding the impact of past events, currentconditions and the likelihood of future events and the timing of cash flows,including any recoveries. After giving consideration to all the above factors,management concluded that an other-than-temporary impairment had occurred andrecorded a $1,489,000 impairment charge through earnings on this trustpreferred security with an original par value of $1,750,000.

 

The following Investment Portfolio table reflects the amortized costand fair market values for the total portfolio for each of the categories ofinvestments for the past three years.

 

Federal funds sold comprise the remainder of theassets that are not invested in the securities portfolio or in the loanportfolio.  These overnight transactionsare highly liquid and are returned to the Company the next day.  The Company sold $36.6 million and $54.3million as of December 31, 2008 and December 31, 2007.

 

47

----

Table of Contents

 

**Investment Portfolio**

(dollarsin thousands)

 
| ** **                                     | ** ** | **As of December 31,** | ** ** |
|------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                     | ** ** | **2008**                              | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                     | ** ** | **Amortized  Cost**                   | ** ** | **Fair  Market  Value** | ** ** | **Amortized  Cost** | ** ** | **Fair  Market  Value** | ** ** | **Amortized  Cost** | ** ** | **Fair  Market  Value** | ** ** |
| **Available for sale**               | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| US Government Agencies & Corporations | ** ** | $                                     | 5,080      |   | $ | 5,094 |   | $ | 3,282 |   | $ | 3,287 |   | $ | 1,977 |   | $ | 1,961 | ** ** |
| State & political subdivisions        |       | 1,358                                 |       | 1,368 |   | 1,357 |   | 1,381 |   | 1,357 |   | 1,389 |   |
| **Total available for sale**                   |       | 6,438                                 |       | 6,462 |   | 4,639 |   | 4,668 |   | 3,334 |   | 3,350 |   |
| **Held to maturity**                           |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| US Government Agencies & Corporations |       | 373                                   |       | 377 |   | 1,596 |   | 1,602 |   | 1,777 |   | 1,759 |   |
| Other securities                               |       | 261                                   |       | 261 |   | — |   | — |   | — |   | — |   |
| **Total held to maturity**                     |       | 634                                   |       | 638 |   | 1,596 |   | 1,602 |   | 1,777 |   | 1,759 |   |
| **Total Investment Securities**                |       | $                                     | 7,072      |   | $ | 7,100 |   | $ | 6,235 |   | $ | 6,270 |   | $ | 5,111 |   | $ | 5,109 |   |

 

The investment maturities table below summarizes the maturity of theCompany’s investment securities and their weighted average yields at December 31,2008. Expected remaining maturities may differ from remaining contractualmaturities because obligors may have the right to repay certain obligationswith or without penalties.

 

**Investment Maturities**

(dollars in thousands)

 
| ** **                                      |   | **As of  December 31, 2008** |       |
|-------------------------------------------------|--------|-----------------------------------|------------|
| ** **                                      |   | **Within  One  Year**             | ** ** | **After  One But  Within Five  Years** | ** ** | **After  Five Years  But Within Ten  Years** | ** ** | **After  Ten  Years** | ** ** | **Total** |   |
| ** **                                      |   | **Amount**                        | ** ** | **Yield** | ** ** | **Amount** | ** ** | **Yield** | ** ** | **Amount** | ** ** | **Yield** | ** ** | **Amount** | ** ** | **Yield** | ** ** | **Amount** | ** ** | **Yield** |   |
| **Available  for sale**                         |   |                              |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| US Government  agencies & corporations |   | —                            |       |   |   | 3,014 |   | 3.91 | % | 2,080 |   | 5.28 | % | — |   | — |   | 5,094 |   | 4.47 | % |
| State &  political subdivisions        |   | —                            |       | — |   | — |   |   |   | 498 |   |   |   | 870 |   | 7.17 | % | 1,368 |   | 7.17 | % |
| **Total  available for sale**                   |   | $                                 | —     |   |   |   | $ | 3,014 |   | 3.91 | % | $ | 2,578 |   | 5.28 | % | $ | 870 |   | 7.17 | % | $ | 6,462 |   | 5.04 | % |
| **Held to  Maturity**                           |   |                              |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| US Government  agencies & corporations |   | —                            |       | — |   | 321 |   | 4.08 | % | 53 |   | 6.00 | % | — |   | — |   | 374 |   | 2.56 | % |
| Other securities                                |   | —                            |       |   |   | — |   |   |   | — |   |   |   | 261 |   | 9.45 | % | 261 |   |   |   |
| **Total  held to maturity**                     |   | $                                 | —     |   | — |   | $ | 321 |   | 4.08 | % | 53 |   | 6.00 | % | $ | 261 |   | 9.45 | % | $ | 634 |   | 2.56 | % |
| **Total  investment securities**                |   | $                                 | —     |   | — |   | $ | 3,335 |   | 3.93 | % | $ | 2,631 |   | 4.29 | % | $ | 1,131 |   | 7.70 | % | $ | 7,097 |   | 4.82 | % |

 

**Cash and Due From Banks**

 

Cash on hand and balances due from correspondent banks represent themajor portion of the Company’s non-earning assets. At December 31, 2008these areas comprised 3.7% of total assets, as compared to 5.5% of total assetsat December 31, 2007. The Company strives to maintain vault cash at alevel consistent with the withdrawal needs of the customers. The vault cashamount for December 31, 2008 was $4.5 million.

 

The Company’s operating branches lie within the Federal Reserve Bank(FRB) of San Francisco’s responsibility area of check clearing activities,while the Company’s item processing activities are performed in Chico. As aresult of the Federal Reserve Banks’ Check 21 services the Companyis taking advantage of quicker clearing times to offset timezone and geography challenges and improve availability. With traditional papercheck clearing, all non-local and country items in the 12th District receive availability that is at leastone day deferred. Under the programs currently available from the FederalReserve Banks, many of these items receive immediate availability ifreceived by the 1:00 a.m. Pacific time deadline. With file depositdeadlines starting as early as 5:00 p.m. Pacific through 9:00 a.m.Pacific time, image cash letters enable institutions on the West Coast toreduce the clearing time of many high value East Coast items by at least onebusiness day, thereby increasing funds available for investment and reducingrisk.

 

48

----

Table of Contents

 

###### **Premises and Equipment**

######  

Premises and equipment are stated at cost less accumulated depreciationand amortization. Depreciation is charged to income over the estimated usefullives of the assets and leasehold improvements are amortized over the terms ofthe related lease, or the estimated useful lives of the improvements, whicheveris shorter. Depreciation expense was $2,084,000 for the year ended December 31,2008 as compared to $2,108,000 during 2007 and $1,662,000 during 2006. Thefollowing premises and equipment table reflects the balances by major categoryof fixed assets:

 

**Premises & Equipment**

(dollars in thousands)

 
| ** **                | ** ** | **As of December 31,** | ** ** |
|---------------------------|------------|---------------------------------------|------------|
| ** **                | ** ** | **2008**                              | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                | ** ** | **Cost**                              | ** ** | **Accumulated  Depreciation** | ** ** | **Net Book  Value** | ** ** | **Cost** | ** ** | **Accumulated  Depreciation** | ** ** | **Net Book  Value** | ** ** | **Cost** | ** ** | **Accumulated  Depreciation** | ** ** | **Net Book  Value** | ** ** |
| Land                      |       | $                                     | —     |   | $ | — |   | $ | — |   | $ | 2,176 |   | $ | — |   | $ | 2,176 |   | $ | 2,176 |   | $ | — |   | $ | 2,176 |   |
| Buildings                 |       | 3,454                                 |       | 305 |   | 3,149 |   | 12,927 |   | 2,069 |   | 10,858 |   | 8,713 |   | 1,714 |   | 6,999 |   |
| Leasehold  Improvements   |       | 2,469                                 |       | 1,161 |   | 1,308 |   | 2,485 |   | 849 |   | 1,636 |   | 2,258 |   | 555 |   | 1,703 |   |
| Construction in  progress |       | —                                |       | — |   | — |   | 31 |   | — |   | 31 |   | 2,368 |   | — |   | 2,368 |   |
| Furniture and  Equipment  |       | 10,754                                |       | 8,198 |   | 2,556 |   | 9,867 |   | 6,663 |   | 3,203 |   | 8,282 |   | 6,169 |   | 2,113 |   |
| **Total**                 |       | $                                     | 16,677     |   | $ | 9,664 |   | $ | 7,013 |   | $ | 27,486 |   | $ | 9,581 |   | $ | 17,905 |   | $ | 23,797 |   | $ | 8,438 |   | $ | 15,359 |   |

 

The net book value of the Company’s premises and equipment decreased by$10,892,000 during 2008, primarily due to the sale and lease back transactionof seven buildings in February 2008.   As a percentage of total assets, the Company’s premises and equipmentwas 1.2%, at the end of 2008, 3.1% at the end of 2007 and 2.8% at the end of2006.

 

###### **Deposits**

######  

The composition and cost of the Company’s deposit base are importantcomponents in analyzing the Company’s net interest margin and balance sheetliquidity characteristics, both of which are discussed in greater detail inother sections herein. Net interest margin is improved to the extent thatgrowth in deposits can be concentrated in historically lower-cost coredeposits, namely non-interest-bearing demand, NOW accounts, savings accountsand money market deposit accounts. Liquidity is impacted by the volatility ofdeposits or other funding instruments, or in other words their propensity toleave the institution for rate-related or other reasons. Potentially, the mostvolatile deposits in a financial institution are large certificates of deposit,which generally mean time deposits with balances exceeding $100,000. Becausethese deposits (particularly when considered together with a customer’s otherspecific deposits) may exceed FDIC insurance limits, depositors may selectshorter maturities to offset perceived risk elements associated with depositsover $100,000.  The temporary increase inthe insurance limit to $250,000 effective through December 31, 2009 shouldhelp mitigate any perceived risk on time deposits maturing prior to thatdate.  In addition, the Bank isparticipating in the FDIC Transaction Account Guarantee Program.  Under that program, through December 31,2009, all noninterest-bearing transaction accounts are fully guaranteed by theFDIC for the entire amount in the account. Coverage under the Transaction Account Guarantee Program is in additionto and separate from the coverage available under the FDIC’s general depositinsurance rules.  Certificates ofdeposits exceeding $100,000 represented 16.8% of average total deposits in2008, 14.7% in 2007 and 15.9% in 2006. While the total of these deposits has been stable over the past threeyears, the Company’s community-oriented deposit gathering activities in Butte,Colusa, Shasta, Sutter, Tehama, and Yuba counties have engendered a lessvolatile than usual base of depositor certificates over $100,000.

 

The Company’s total deposit volume increased to $526 million at the endof 2008, as compared to $501 million at the end of 2007. Deposit growth of $25million was achieved during 2008.  Themix of the core deposits (demand deposits, savings, NOW, and money market) wasrelatively unchanged from 2007 to 2008. Growth was achieved in non interestbearing demand deposits of $4.6 million. Savings deposit totals were down by $4.3 million, money market accountbalances were down by $6 million and time deposits were up by $28.4 million. Weexpect deposit rates to be lower in 2009, and our focus will be to attractdeposits at the lowest cost possible to fund our loans and maintain areasonable net interest margin in 2009.

 

49

----

Table of Contents

 

The scheduled maturity distribution of the Company’s time deposits,including IRA accounts as of December 31, 2008 was as follows:

 

**Deposit Maturity Distribution**

(dollars in thousands)

 
| ** **                  | ** ** | **As of December 31, 2008** | ** ** |
|-----------------------------|------------|-------------------------------------------------|------------|
| ** **                  | ** ** | **Three  months or  less**                 | ** ** | **Three to  twelve  months** | ** ** | **One to  three  years** | ** ** | **Over  three  years** | ** ** | **Total** | ** ** |
| Time Deposits < $100,000 |       | $                                               | 23,451     |   | $ | 55,101 |   | $ | 4,583 |   | $ | 462 |   | $ | 83,597 |   |
| Time Deposits > $100,000 |       | $                                               | 37,531     |   | $ | 60,749 |   | $ | 3,872 |   | $ | 2,166 |   | $ | 104,318 |   |
| TOTAL                       |       | $                                               | 60,982     |   | $ | 115,850 |   | $ | 8,455 |   | $ | 2,628 |   | $ | 187,915 |   |

 

**Notes Payable and Other Borrowings**

 

The Company has $15 million in unsecured borrowing arrangements withtwo of its correspondent banks to meet short-term liquidity needs. There were noborrowings outstanding under these arrangements at December 31, 2008 and2007.

 

On July 10, 2007 Community Valley formed a wholly-ownedsubsidiary, Community Valley Bancorp Trust II (the “Trust”), which is aDelaware statutory business trust, for the purpose of issuing trust preferredsecurities. The proceeds from the Trust were used in 2008 to redeem 100% of thetrust preferred securities issued by the 2002 Community Valley Bancorp TrustI.  After redemption Community ValleyTrust I was dissolved .

 

The following summarizes the note payable to the Company’s subsidiarygrantor trust at December 31, 2008:

 

| ** **                                                                                                                                                                                                                                                                                                                     | ** ** | **(Dollars in   thousands)** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| Subordinated debentures due to Community  Valley Bancorp Trust II with interest fixed and payable quarterly based on  the 5 year swap rate benchmark of 5.57% plus 1.57% Libor for the first 5  years; then converting to 3-month LIBOR plus 1.57% for remaining term,  beginning July 10, 2007, due October 1, 2037 |       | $                                 | 8,248      |   |
|                                                                                                                                                                                                                                                                                                                                |            |                                   |            |  |

 

The Company has guaranteed, on a subordinated basis, distributions andother payments due on trust preferred securities issued by the subsidiarygrantor trust. Interest expense recognized by the Company for the years ended December 31,2008, 2007 and 2006 related to the junior subordinated debentures was $566,000,$1,024,000 and $733,000, respectively. These junior subordinated debenturescurrently qualify as Tier 1 capital when determining regulatory risk-basedcapital ratios.

 

On April 28, 2006 the ESOP obtained financing through a $1.3million unsecured line of credit from another financial institution with theCompany acting as the guarantor. The note has a variable interest rate, basedon an independent index, and a maturity date of April 10, 2014. In November 2008a change in terms was done on the ESOP note which increased the line back to$1,300,000 with a new maturity date of October 10, 2016.  At December 31, 2008, the interest ratewas 5.75%. Advances on the line of credit totaled $121,000, $1,093,000,$1,217,000 at December 31, 2008, 2007 and 2006, respectively. A summary ofthe activity in this line of credit follows.

 

On June 30,2008 the Company obtained a Line of Credit in the amount of $4,000,000 from acorrespondent bank.  The note has avariable interest rate, based on LIBOR plus 3.25% with a floor of 5.75%, and amaturity date of June 30, 2010. Quarterly payments are interest only. At December 31, 2008, the interest rate was 5.75%.  Advances on the line of credit totaled$4,000,000 at December 31, 2008.

 

50

----

Table of Contents

 

ESOP Note Payable

(dollars in thousands)

 
|                                        | ** ** | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|---------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                        |       |     |       |     |       |     |       |
| Balance at December 31                 |       | $        | 1,054      |     | $          | 1,092    |       | $ | 1,217 |   |
|                                        |       |     |       |     |       |     |       |
| Average amount outstanding                  |       | $        | 1,026      |     | $          | 1,150    |       | $ | 1,068 |   |
|                                        |       |     |       |     |       |     |       |
| Maximum amount outstanding at any month end |       | $        | 1,082      |     | $          | 1,215    |       | $ | 1,142 |   |
|                                        |       |     |       |     |       |     |       |
| Average interest rate for the year          |       | 5.54     | %          | 8.08     | %          | 7.94     | %          |

 

Other Note Payable

(dollars in thousands)

 
|                                        |   | **2008** | ** ** | **2007** | ** ** | **2006** | ** ** |
|---------------------------------------------|--------|----------|------------|----------|------------|----------|------------|
|                                        |   |     |       |     |       |     |       |
| Balance at December 31                 |   | $        | 4,000      |     | $          | —   |       | $ | — |   |
|                                        |   |     |       |     |       |     |       |
| Average amount outstanding                  |   | $        | 2,000      |     | $          | —   |       | $ | — |   |
|                                        |   |     |       |     |       |     |       |
| Maximum amount outstanding at any month end |   | $        | 4,000      |     | $          | —   |       | $ | — |   |
|                                        |   |     |       |     |       |     |       |
| Average interest rate for the year          |   | 6.67     | %          | —   |       | —   |       |

 

###### **Capital Resources**

######  

At December 31, 2008, the Company had total shareholders equity of$40.1 million, comprised of $8.7 million in common stock, net of theunallocated ESOP shares, and $31.4 million in retained earnings. Total shareholdersequity at the end of 2007 was $51 million. The primary decrease in shareholders’equity was from the $13,118,000 tender offer completed in 2008.  Net income has provided $16.3 million incapital over the last three years, of which $5.5 million or approximately 33%was distributed in dividends. The retention of earnings has been the Company’smain source of capital since 1990, however the Company issued $8.2 million inSubordinated Debentures in 2007 (used in 2008 to refund the 2002 SubordinatedDebentures), the proceeds of which are considered Tier 1 capital for regulatorypurposes but long-term debt in accordance with GAAP.

 

The Company paid quarterly cash dividends totaling $1,148,000 or $.16per share in 2008 and $2,425,000 or $.32 per share in 2007, representing 41.9%and 37.5%, respectively of those year’s earnings.  Since the second quarter of 2001, the Companyhas adhered to a policy of paying quarterly cash dividends totaling about 22.5%of the prior year’s net earnings to the extent consistent with generalconsiderations of safety and soundness, provided that such payments do notadversely affect the Bank’s or the Company’s financial condition and are notoverly restrictive to its growth capacity. The Company chose to suspend payingdividends in the fourth quarter of 2008. Any future payment of dividends will be consistent with the generaldividend policy as described above. However, no assurance can be given that theBank’s and the Company’s future earnings and/or growth expectations in any givenyear will justify the payment of such a dividend.

 

The Company uses a variety of measures to evaluate capital adequacy.Management reviews various capital measurements on a monthly basis and takesappropriate action to ensure that such measurements are within establishedinternal and external guidelines. The external guidelines, which are issued bythe FDIC, establish a risk-adjusted ratio relating capital to differentcategories of assets and off balance sheet exposures. There are two categoriesof capital under the FDIC guidelines: Tier 1 and Tier 2 Capital. Tier 1 Capitalincludes common shareholders’ equity and the proceeds from the issuance oftrust-preferred securities (subject to the limitations previously discussed),less goodwill and certain other deductions, notably the unrealized net gains orlosses (after tax adjustments) on securities available for sale, which arecarried at fair market value. Tier 2 Capital includes preferred stock andcertain types of debt equity, which the Company does not hold, as well as theallowance for loan losses, subject to certain limitations. (For a more detaileddefinition, see “Item 1, Business-Supervision and Regulation — Capital AdequacyRequirements” herein.)

 

51

----

Table of Contents

 

Wemay need to incur additional debt or equity financing in the future to meet ourcapital needs. We cannot guarantee that such financing will be available to uson acceptable terms or at all. If we are unable to obtain future financing, wemay not have the resources available to fund our planned growth.

 

At December 31, 2008, the Company had a Tier 1 risk based capitalratio of 8.8%, a total capital to risk-weighted assets ratio of 10.0%, and aleverage ratio of 8.1%. The Company had a Tier 1 risk based capital ratio of13.1%, a total capital to risk-weighted assets ratio of 14.1%, and a leverageratio of 11.6% at December 31, 2007. Note 11 of the Notes to ConsolidatedFinancial Statements provides more detailed information concerning the Company’scapital amounts and ratios as of December 31, 2008 and 2007.

 

At the current time, the Bank is considered “well capitalized” underthe Prompt Corrective Action standards.

 

****Off-Balance Sheet Itemsand Contractual Obligations****

 

The Company has certain ongoing commitments underoperating leases. See Note 10 to the consolidated financial statements at Item8 of this report for the terms. These commitments do not significantly impactoperating results. As of December 31, 2008 commitments to extend creditand stand-by-letters of credit were the Company’s only financial instrumentswith off-balance sheet risk. Loan commitments decreased to $148 million at December 31,2008 from $184 million at December 31, 2007. Stand-by-letters of creditdecreased slightly to $6.5 million from $6.7 million over the same period.  The commitments and stand-by letters ofcredit represent 34% of the total loans outstanding at year-end 2008 versus 43%at December 31, 2007.

 

The following chart summarizes certain contractual obligations of the Company as of December 31, 2008:

 
| ** **                    | ** ** | **Less than  1 year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **More than  5 years** | ** ** | **Total** | ** ** |
|-------------------------------|------------|---------------------------------|------------|--------------------|------------|--------------------|------------|----------------------------------|------------|-----------|------------|
|                          |       |                            |       |               |       |               |       |                             |       |      |       |
| Subordinated debenture        |       | $                               | —     |               | $          | —             |       | $                                | —     |      | $          | 8,248 |   | $ | 8,248 |   |
| Operating lease obligations   |       | 2,182                           |       | 4,124              |       | 3,659              |       | 16,108                           |       | 26,073    |       |
| Deferred compensation **(1)** |       | —                          |       | —             |       | —             |       | 5,837                            |       | 5,837     |       |
| Supplemental retirement plans |       | 123                             |       | 391                |       | 428                |       | 978                              |       | 1,920     |       |
| Notes payable                 |       | —                          |       | 4,000              |       | —             |       | 1,054                            |       | 5,054     |       |
| Total contractual obligations |       | $                               | 2,305      |               | $          | 8,515              |       | $                                | 4,087      |      | $          | 32,225 |   | $ | 47,132 |   |

 

----

(1) These amounts represent the accruedliabilities as of December 31, 2008 under the Company’s deferredcompensation and supplemental retirement plans. See Note 15 to the consolidatedfinancial statements at Item 8 of this report for additional informationrelated to the Company’s deferred compensation and supplemental retirement planliabilities. 

 

###### **Liquidity and Market Risk Management**

######  

Globalfinancial markets recently have been, and continue to be, extremely unstableand unpredictable, and economic conditions have been weak and appear to bedeteriorating. Continued, and potentially increased, volatility, instabilityand weakness could affect the Company’s ability to sell investment securitiesand other financial assets, which in turn could adversely affect the Company’sliquidity and financial position. This instability also could affect the pricesat which the Company could make any such sales, which could adversely affectits earnings and financial condition. Conditions could also negatively affectthe Company’s ability to secure funds or raise capital.

 

The Company must address on a daily basis the various and sundryfactors which impact its continuing operations. Three of these factors, theeconomic climate which encompasses our business environment, the regulatoryframework which governs our practices and procedures, and credit risk have beenpreviously discussed. There are other risks specific to the operation of afinancial institution which also need to be managed, and this section willaddress liquidity risk and market risk.

 

Liquidity refers to the Company’s ability to maintain a cash flowadequate to fund operations, and to meet obligations and other commitments in atimely and cost-effective fashion. At various times the Company requires fundsto meet short-term cash requirements brought about by loan growth or depositoutflows, the purchase of assets, or liability repayments. To manage liquidityneeds properly, cash inflows must be timed to coincide with anticipatedoutflows, or sufficient liquidity resources must be available to meet varyingdemands. The Company manages its own liquidity in such a fashion as to be ableto meet unexpected sudden changes in levels of its assets or depositliabilities, without maintaining excessive amounts of on-balance sheetliquidity. Excess balance sheet liquidity can negatively impact the interestmargin.

 

52

----

Table of Contents

 

An integral part of the Company’s ability to manage its liquidityposition appropriately is provided by the Company’s large base of coredeposits, which were generated by offering traditional banking services in thecommunities in its service area and which have, historically, been a verystable source of funds.

 

Additionally, the Company maintains $15 million in unsecured borrowingarrangements with two of its correspondent banks. The Company also has theability to raise deposits through various deposit brokers, sell investmentsecurities, or sell loans if required for liquidity purposes.

 

Market risk arises from changes in interest rates, exchange rates,commodity prices and equity prices. The Company’s market risk exposure isprimarily that of interest rate risk, and it has risk management policies tomonitor and limit earnings and balance sheet exposure to changes in interestrates. The Company does not engage in the trading of financial instruments.

 

The principal objective of interest rate risk management (oftenreferred to as “asset/liability management”) is to manage the financialcomponents of the Company in a manner that will optimize the risk/rewardequation for earnings and capital in relation to changing interest rates. Inorder to identify areas of potential exposure to rate changes, the Companycalculates its re-pricing gap on a monthly basis. It also performs an earningssimulation analysis and a market value of portfolio equity calculation on amonthly basis to identify more dynamic interest rate risk exposures than thoseapparent in the standard re-pricing gap analysis.

 

Modeling software is used by the Company for asset/liability managementin order to simulate the effects of potential interest rate changes on theCompany’s net interest margin. These simulations can also provide both staticand dynamic information on the projected fair market values of the Company’sfinancial instruments under differing interest rate assumptions. The simulationprogram utilizes specific individual loan and deposit maturities, embeddedoptions, rates and re-pricing characteristics to determine the effects of agiven interest rate change on the Company’s interest income and interest expense.Rate scenarios consisting of key rate and yield curve projections are runagainst the Company’s investment, loan, deposit and borrowed funds portfolios.These rate projections can be shocked (an immediate and sustained change inrates, up or down), ramped (an incremental increase or decrease in rates over aspecified time period), economic (based on current trends and econometricmodels) or stable (unchanged from current actual levels). The Company typicallyuses seven standard interest rate scenarios in conducting the simulation,namely stable, an upward shock of 100, 200, and 300 basis points, and adownward shock of 100, 200, and 300 basis points.  The Company’s policy is to limit the changein the Company’s net interest margin and economic value to plus or minus 10%,20%, and 30% and 10%, 15%, and 20% respectively upon application of interestrate shocks of 100 bp, 200 bp, and 300 bp as compared to a base rate scenario.As of December 31, 2008, the Company had the following estimated netinterest margin sensitivity profile:

 
| ** **                 | ** ** | **Immediate Change in Rate** | ** ** | **Immediate Change in Rate** | ** ** | **Immediate Change in Rate** | ** ** |
|----------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|
| ** **                 | ** ** | **+100 bp**                            | ** ** | **-100 bp**                            | ** ** | **+200 bp**                            | ** ** | **-200 bp** | ** ** | **+300 bp** | ** ** | **-300 bp** | ** ** |
| Net Interest Income Change |       | $                                           | 1,793,000  |                                        | $          | 103,000                                     |       | $ | 3,522,000 |   | $ | 328,000 |   | $ | 5,194,000 |   | $ | 923,000 |   |
|                            |            |                                             |            |                                             |            |                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

The above profile illustrates that if there were an immediate increaseof 200 basis points in interest rates, the Company’s annual net interest incomewould likely increase by about $3,522,000, or approximately 15.5%. Likewise, ifthere were an immediate downward adjustment of 200 basis points in interestrates, the Company’s net interest income would likely increase by approximately$328,000, or 1.44%, over the next year. Many of the Company’s loans have variable rates with minimum thresholdscalled floors that they can adjust to in a falling rate environment.  For this reason, the Company would realizepositive net interest income in the three rate reduction scenarios shown above.  The results for the Company’s December 31,2008, balances indicate that the Company’s net interest income at risk over aone-year period and net economic value at risk from 2% shocks are within normalexpectations for such sudden changes.

 

The amount of change is based on the profiles of each loan and depositclass, which include the rate, the likelihood of prepayment or repayment,whether its rate is fixed or floating, the maturity of the instrument, and theparticular circumstances of the customer. The quantification of the change ineconomic value is somewhat apparent in Note 16, Fair Value of FinancialInstruments, in the consolidated financial statements; however such valueschange over time based on certain assumptions about interest rates and likelychanges in the yield curve.

 

53

----

Table of Contents

 

**SelectedQuarterly Financial Data**

(Dollars in thousands, except per share data)

 
| **2008 Quarter**                                | ** ** | **1st** | ** ** | **2nd** | ** ** | **3rd** | ** ** | **4th** | ** ** |
|------------------------------------------------------|------------|---------|------------|---------|------------|---------|------------|---------|------------|
|                                                 |       |    |       |    |       |    |       |    |       |
| Interest income                                      |       | $       | 9,611      |    | $          | 9,298   |       | $       | 9,471      |   | $ | 8,935 |   |
| Net interest income                                  |       | $       | 6,671      |    | $          | 6,716   |       | $       | 7,032      |   | $ | 6,531 |   |
| Net interest income after provision for  loan losses |       | $       | 6,446      |    | $          | 6,266   |       | $       | 6,282      |   | $ | 4,781 |   |
|                                                 |       |    |       |    |       |    |       |    |       |
| Net income                                           |       | $       | 824        |    | $          | 1,043   |       | $       | 1,302      |   | $ | (430 | ) |
|                                                 |       |    |       |    |       |    |       |    |       |
| Net income per share, basic                          |       | $       | 0.11       |    | $          | 0.15    |       | $       | 0.20       |   | $ | (0.07 | ) |
|                                                 |       |    |       |    |       |    |       |    |       |
| Net income per share, diluted                        |       | $       | 0.11       |    | $          | 0.15    |       | $       | 0.20       |   | $ | (0.07 | ) |
|                                                 |       |    |       |    |       |    |       |    |       |
| Dividends declared                                   |       | $       | 0.08       |    | $          | 0.04    |       | $       | 0.04       |   | $ | — |   |

 
| **2007  Quarter**                                    | ** ** | **1st** | ** ** | **2nd** | ** ** | **3rd** | ** ** | **4th** | ** ** |
|------------------------------------------------------|------------|---------|------------|---------|------------|---------|------------|---------|------------|
|                                                 |       |    |       |    |       |    |       |    |       |
| Interest income                                      |       | $       | 10,615     |    | $          | 10,960  |       | $       | 11,128     |   | $ | 10,520 |   |
| Net interest income                                  |       | $       | 7,234      |    | $          | 7,497   |       | $       | 7,581      |   | $ | 7,022 |   |
| Net interest income after provision for  loan losses |       | $       | 7,159      |    | $          | 7,497   |       | $       | 7,506      |   | $ | 6,947 |   |
|                                                 |       |    |       |    |       |    |       |    |       |
| Net income                                           |       | $       | 1,250      |    | $          | 1,642   |       | $       | 2,179      |   | $ | 1,388 |   |
|                                                 |       |    |       |    |       |    |       |    |       |
| Net income per share, basic                          |       | $       | 0.17       |    | $          | 0.22    |       | $       | 0.29       |   | $ | 0.19 |   |
|                                                 |       |    |       |    |       |    |       |    |       |
| Net income per share, diluted                        |       | $       | 0.17       |    | $          | 0.22    |       | $       | 0.29       |   | $ | 0.18 |   |
|                                                 |       |    |       |    |       |    |       |    |       |
| Dividends declared                                   |       | $       | 0.08       |    | $          | 0.08    |       | $       | 0.08       |   | $ | 0.08 |   |

 

**Item 7a. Quantitative and QualitativeDisclosures About Market Risk**

 

The information required by Item 7a of Form 10-K is contained inthe Liquidity and Market Risk Management section of Item 7 — ManagementsDiscussion and Analysis of Financial Condition and Results of Operations.

 

**Item 8.****    FinancialStatements and Supplementary Data**

 

The financial statements begin on page 64 of this report.

 

**Item 9.****    Changesin and Disagreements with Accountants on Accounting and Financial Disclosure**

 

There were no changes or disagreements with Accountants for the year2008.

 

# **Item 9a.****  Controlsand Procedures**

#  

As of the end of the period covered by this report, we conducted anevaluation, under the supervision and with the participation of our ChiefExecutive Officer and Chief Financial Officer, of our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934).  Based on this evaluation, our ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols and procedures are effective to ensure that information required to bedisclosed by us in reports that we file or submit under the Exchange Act isrecorded, processed, summarized and reported within the time periods specifiedin Securities and Exchange Commission rules and forms.  There was nochange in our internal control over financial reporting during our mostrecently completed fiscal quarter that has materially affected, or is reasonablylikely to materially affect, our internal control over financial reporting.

 

54

----

Table of Contents

 

**REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING**

 

Management of Community ValleyBancorp and its subsidiaries (the Company) is responsible for establishing andmaintaining adequate internal control over financial reporting for the Company,as such term is defined in Rule 13a-15(f) under the SecuritiesExchange Act of 1934.  The Company’smanagement, including the chief executive officer and chief financial officer,has assessed the effectiveness of the Company’s internal control over financialreporting as of December 31, 2008, presented in conformity with accountingprinciples generally accepted in the United States of America. In making thisassessment, management used the criteria set forth by the Committee ofSponsoring Organizations of the Treadway Commission in Internal Control-Integrated Framework. Based on this assessment, management concluded that, asof December 31, 2008, the Company’s internal control over financialreporting was effective based on those criteria.

 

This annual report does not include an attestation report of theCompany’s independent registered public accounting firm regarding internalcontrol over financial reporting. Management’s report was not subject toattestation by the Company’s independent registered public accounting firmpursuant to the rules of the Securities and Exchange Commission thatpermit the Company to provide only management’s report in this annual report.

 

**Item 9b. Other Information**

 

Not applicable

 

55

----

Tableof Contents

 

**PART III**

 

**Item 10. Directors and Executive Officers andCorporate Governance**

 

The information required by Item 10 of Form 10-K is incorporatedby reference to the information contained in the Company’s Proxy Statement forthe 2008 Annual Meeting of Shareholders which will be filed pursuant toRegulation 14A.

 

**Item 11. Executive Compensation**

 

The information required by Item 11 of Form 10-K is incorporatedby reference to the information contained in the Company’s Proxy Statement forthe 2008 Annual Meeting of Shareholders which will be filed pursuant toRegulation 14A.

 

**Item 12. Security Ownership of CertainBeneficial Owners and Management and Related Stockholder Matters**

 

The information required by Item 12 of Form 10-K is incorporatedby reference to the information contained in the Company’s Proxy Statement forthe 2008 Annual Meeting of Shareholders which will be filed pursuant toRegulation 14A.

 

**Item 13.****                            CertainRelationships and Related Transactions and Director Independence**

 

The information required by Item 13 of Form 10-K is incorporatedby reference to the information contained in the Company’s Proxy Statement forthe 2008 Annual Meeting of Shareholders which will be filed pursuant toRegulation 14A.

 

**Item 14.****                            PrincipalAccountant Fees and Services**

 

The information required by Item 14 of Form 10-K is incorporatedby reference to the information contained in the Company’s Proxy Statement forthe 2008 Annual Meeting of Shareholders which will be filed pursuant toRegulation 14A.

 

**PART IV**

 

**Item 15.****                            Exhibits,Financial Statement Schedules, and Reports on Form 8-K**.

 

(a)                                  **List of documents filed as part of this report**

 

**(1)**                                 **FinancialStatements**

 

The following financial statements and independent auditor’s reportsare included in this Annual Report on Form 10-K immediately following.

 
| I.   | Report of Independent Registered Public Accounting Firm                                                             |
|------|---------------------------------------------------------------------------------------------------------------------|
| II.  | Consolidated Balance Sheet -  December 31, 2008 and 2007                                                       |
| III. | Consolidated Statement of Income - Years  Ended December 31, 2008, 2007 and 2006                               |
| IV.  | Consolidated Statement of Changes in  Shareholders’ Equity - Years Ended December 31, 2008, 2007 and 2006 |
| V.   | Consolidated Statement of Cash Flows - Years  Ended December 31, 2008, 2007 and 2006                           |
| VI.  | Notes to the Consolidated Financial  Statements                                                                     |

 

**(2)**                        **FinancialStatement Schedules**

 

Schedules to the financial statements are omitted because the requiredinformation is not applicable or because the required information is presentedin the Company’s Consolidated Financial Statements or related notes.

 

56

----

Tableof Contents

 

**(3)**                        **Exhibits**

 

**Exhibits**

 
| **Exhibit** | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                             |
|-------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Number**  | ** ** | **Document Description**                                                                                                                                                                                                                                                                                                                                               |
|        |       |                                                                                                                                                                                                                                                                                                                                                                   |
| (3.1)       |       | Articles  of Incorporation incorporated by reference from the Company’s Registration  Statement Form S-4EF, file #333-85950.                                                                                                                                                                                                                            |
| (3.2)       |       | Bylaws  incorporated by reference from the Company’s Registration Statement  Form S-4EF, file #333-85950.                                                                                                                                                                                                                                               |
| (3.3)       |       | Amendment  to Bylaws of the Company approved by Shareholders May 2006.                                                                                                                                                                                                                                                                                            |
| (4.0)       |       | Specimen  of Company’s Common Stock Certificate incorporated by reference from the  Company’s Registration Statement Form S-4EF, file #333-85950.                                                                                                                                                                                                  |
| (10.1)      |       | Employment  Agreement with Keith C Robbins dated April 27, 1995.  Incorporated  by reference to the Company’s Quarterly Report on Form 10-Q for the  period ended June 30, 2002, filed with the Commission on August 14,  2002.                                                                                                          |
| (10.1)1     |       | Amendment  to Employment Agreement with Keith C. Robbins dated September 12, 2006  incorporated by reference to the Company’s Annual Report on Form 10-K  for the period ended December 31, 2006, filed with the Commission on  March 12, 2007.                                                                                               |
| (10.2)      |       | Salary  Continuation Agreement dated April 14, 1998, and Amendment to Salary  Continuation Agreement dated January 10, 2002, for Keith C Robbins.  Incorporated by reference to the Company’s Quarterly Report on Form 10-Q  for the period ended June 30, 2002, filed with the Commission on  August 14, 2002.                          |
| (10.2)1     |       | Amendment  to Salary Continuation Agreement of April 14, 1998 for Keith C Robbins  dated January 1, 2004  Incorporated by reference to the Company’s  Annual Report on Form 10-K for the period ended December 31, 2003,  filed with the Commission on March 20, 2004.                                                              |
| (10.2)2     |       | Additional  Salary Continuation Agreement with Keith C. Robbins dated September 12,  2006, incorporated by reference to the Company’s Annual Report on  Form 10-K for the period ended December 31, 2006, filed with the  Commission on March 12, 2007.                                                                                       |
| (10.3)      |       | Executive  Supplemental Retirement Plan dated August 1, 2000, and Amendment to  Executive Supplement Retirement Plan dated January 10, 2002, for Keith C  Robbins. Incorporated by reference to the Company’s Quarterly Report on  Form 10-Q for the period ended June 30, 2002, filed with the  Commission on August 14, 2002.          |
| (10.4)      |       | 2000  Stock Option Agreement for Keith C Robbins dated March 14, 2000.  Previously filed as Exhibit 10.5 in the Company’s Quarterly Report on  Form 10-Q for the period ended June 30, 2002, filed with the  Commission on August 14, 2002.                                                                                              |
| (10.5)      |       | Employment  Agreement with John F Coger dated April 27, 1995. Previously filed as  Exhibit 10.6 in the Company’s Quarterly Report on Form 10-Q for the  period ended June 30, 2002, filed with the Commission on August 14,  2002.                                                                                                       |
| (10.6)      |       | Salary  Continuation Agreement dated April 14, 1998, and Amendment to Salary  Continuation Agreement dated January 10, 2002, for John F Coger.  Previously filed as Exhibit 10.7 in the Company’s Quarterly Report on  Form 10-Q for the period ended June 30, 2002, filed with the  Commission on August 14, 2002.                 |
| (10.6)1     |       | Amendment  to Salary Continuation Agreement of April 14, 1998 for John F  Coger dated January 1, 2004.  Previously filed as  Exhibit 10.7.1 in the Company’s Annual Report on Form 10-K for the  period ended December 31, 2003, filed with the Commission on  March 20, 2004.                                            |
| (10.7)      |       | Executive  Supplemental Retirement Plan dated August 1, 2000, and Amendment to  Executive Supplement Retirement Plan dated January 10, 2002, for John F  Coger. Previously filed as Exhibit 10.8 in the Company’s Quarterly  Report on Form 10-Q for the period ended June 30, 2002, filed with  the Commission on August 14, 2002. |
| (10.8)      |       | 2000  Stock Option Agreement for John F. Coger dated March 14, 2000.  Previously filed as Exhibit 10.9 in the Company’s Quarterly Report on  Form 10-Q for the period ended June 30, 2002, filed with the  Commission on August 14, 2002                                                                                                 |
| (10.9)      |       | 2000  Stock Option Agreement for M Robert Ching dated May 1, 2000. Previously  filed as Exhibit 10.11 in the Company’s Quarterly Report on Form 10-Q  for the period ended June 30, 2002, filed with the Commission on  August 14, 2002.                                                                                                 |
| (10.10)     |       | 2000  Stock Option Agreement for Eugene B Even dated May 1, 2000. Previously  filed as Exhibit 10.13 in the Company’s Quarterly Report on  Form 10-Q for the period ended June 30, 2002, filed with the                                                                                                                                       |

 

57

----

Table of Contents

 
|    |   | Commission  on August 14, 2002.                                                                                                                                                                                                                                                                                              |
|---------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (10.11) |   | 2000  Stock Option Agreement for John D Lanam dated May 1, 2000. Previously  filed as Exhibit 10.15 in the Company’s Quarterly Report on  Form 10-Q for the period ended June 30, 2002, filed with the  Commission on August 14, 2002.                                                              |
| (10.12) |   | 2000  Stock Option Agreement for Donald W. Leforce dated May 1, 2000.  Previously filed as Exhibit 10.17 in the Company’s Quarterly Report on  Form 10-Q for the period ended June 30, 2002, filed with the  Commission on August 14, 2002                                                          |
| (10.13) |   | 2000  Stock Option Agreement for Ellis L. Matthews dated May 1, 2000.  Previously filed as Exhibit 10.19 in the Company’s Quarterly Report on  Form 10-Q for the period ended June 30, 2002, filed with the  Commission on August 14, 2002                                                          |
| (10.14) |   | 2000  Stock Option Agreement for Robert L. Morgan dated May 1, 2000. Previously  filed as Exhibit 10.21 in the Company’s Quarterly Report on  Form 10-Q for the period ended June 30, 2002, filed with the  Commission on August 14, 2002                                                           |
| (10.15) |   | 2000  Stock Option Agreement for James S. Rickards dated May 1, 2000.  Previously filed as Exhibit 10.23 in the Company’s Quarterly Report on  Form 10-Q for the period ended June 30, 2002, filed with the  Commission on August 14, 2002                                                          |
| (10.16) |   | 2000  Stock Option Agreement for Gary B Strauss dated May 1, 2000. Previously  filed as Exhibit 10.25 in the Company’s Quarterly Report on  Form 10-Q for the period ended June 30, 2002, filed with the  Commission on August 14, 2002.                                                            |
| (10.17) |   | 2000  Stock Option Agreement for Hubert I. Townshend dated May 1, 2000.  Previously filed as Exhibit 10.27 in the Company’s Quarterly Report on  Form 10-Q for the period ended June 30, 2002, filed with the  Commission on August 14, 2002                                                        |
| (10.18) |   | Director  Deferred Fee Agreement for M. Robert Ching dated April 8, 1998.  Previously filed as Exhibit 10.28 in the Company’s Quarterly Report on  Form 10-Q for the period ended June 30, 2002, filed with the  Commission on August 14, 2002                                                      |
| (10.19) |   | Director  Retirement Agreement for M. Robert Ching dated April 14, 1998.  Previously filed as Exhibit 10.29 in to the Company’s Quarterly Report  on Form 10-Q for the period ended June 30, 2002, filed with the  Commission on August 14, 2002                                                    |
| (10.20) |   | Director  Retirement Agreement for Eugene B. Even dated April 14, 1998. Previously  filed as Exhibit 10.30 in the Company’s Quarterly Report on  Form 10-Q for the period ended June 30, 2002, filed with the  Commission on August 14, 2002                                                        |
| (10.21) |   | Director  Retirement Agreement for John D Lanam dated April 14, 1998. Previously  filed as Exhibit 10.31 in the Company’s Quarterly Report on  Form 10-Q for the period ended June 30, 2002, filed with the  Commission on August 14, 2002.                                                         |
| (10.22) |   | Director  Deferred Fee Agreement for Donald W. Leforce dated April 14, 1998.  Previously filed as Exhibit 10.32 in to the Company’s Quarterly Report  on Form 10-Q for the period ended June 30, 2002, filed with the  Commission on August 14, 2002                                                |
| (10.23) |   | Director  Retirement Agreement for Donald W. Leforce dated April 14, 1998.  Previously filed as Exhibit 10.33 in the Company’s Quarterly Report on  Form 10-Q for the period ended June 30, 2002, filed with the  Commission on August 14, 2002                                                     |
| (10.24) |   | Director  Retirement Agreement for Ellis L Matthews dated April 14, 1998.  Previously filed as Exhibit 10.34 in the Company’s Quarterly Report on  Form 10-Q for the period ended June 30, 2002, filed with the  Commission on August 14, 2002.                                                     |
| (10.25) |   | Director  Retirement Agreement for Robert L. Morgan dated April 14, 1998.  Previously filed as Exhibit 10.35 in the Company’s Quarterly Report on  Form 10-Q for the period ended June 30, 2002, filed with the Commission  on August 14, 2002                                                      |
| (10.26) |   | Director  Retirement Agreement James S. Rickards dated April 14, 1998. Previously  filed as Exhibit 10.36 in the Company’s Quarterly Report on  Form 10-Q for the period ended June 30, 2002, filed with the  Commission on August 14, 2002                                                         |
| (10.27) |   | Director  Retirement Agreement for Gary B Strauss dated April 14, 1998. Previously  filed as Exhibit 10.37 in the Company’s Quarterly Report on  Form 10-Q for the period ended June 30, 2002, filed with the  Commission on August 14, 2002.                                                       |
| (10.28) |   | Director  Retirement Agreement for Hubert I Townshend dated April 14, 1998.  Previously filed as Exhibit 10.38 in the Company’s Quarterly Report on  Form 10-Q for the period ended June 30, 2002, filed with the  Commission on August 14, 2002.                                                   |
| (10.29) |   | Lease  agreement between Butte Community Bank and Anna Laura Schilling Trust dated  March 20, 2001, related to 900 Mangrove Ave, Chico, California.  Previously filed as Exhibit 10.39 in the Company’s Quarterly Report on  Form 10-Q for the period ended June 30, 2002, filed with the  Commission on |

 

58

----

Table of Contents

 
|    |   | August 14,  2002.                                                                                                                                                                                                                                                         |
|---------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (10.30) |   | 2000  Stock Option Agreement for Charles J Mathews dated October 21, 2003.  Previously filed as Exhibit 10.30 in the Company’s Annual Report on  Form 10-K for the period ended December 31, 2005, filed with the  Commission on March 14, 2006. |
| (10.31) |   | 2000  Stock Option Agreement for Luther W McLaughlin dated March 10, 2003.  Previously filed as Exhibit 10.41 in the Company’s Annual Report on  Form 10-K for the period ended December 31, 2005, filed with the  Commission on March 14, 2006  |
| (11)    |   | See  Item 6. Selected Financial Data Note 1 for Statement re computation of  earnings per share                                                                                                                                                                                |
| (12)    |   | See  Item 6. Selected Financial Data Notes 2 through 6 for Statements re  computation of ratios                                                                                                                                                                                |
| (21)    |   | List  of Subsidiaries: Butte Community Bank, Butte Community Insurance Agency LLC,  Community Valley Trust II (unconsolidated) as listed in text of document                                                                                                                   |
| (23.1)  |   | Consent  of Independent Registered Public Accounting Firm                                                                                                                                                                                                                      |
| (31.1)  |   | Rule 13a-14(a)/15d-14(a) certification  of Chief Executive Officer                                                                                                                                                                                                   |
| (31.2)  |   | Rule 13a-14(a)/15d-14(a) certification  of Chief Financial Officer                                                                                                                                                                                                   |
| (32.1)  |   | Section 1350  certification of Chief Executive Officer                                                                                                                                                                                                                    |
| (32.2)  |   | Section 1350  certification of Chief Financial Officer                                                                                                                                                                                                                    |
|    |   |                                                                                                                                                                                                                                                                           |
| (99.2)  |   | 1997  Stock Option Plan is incorporated by reference from the Company’s  Registration Statement Form S-8, filed August 14, 2002.                                                                                                                                |
| (99.3)  |   | 2000  Stock Option Plan is incorporated by reference from the Company’s  Registration Statement Form S-8, filed August 14, 2002.                                                                                                                                |
| (99.4)  |   | Director  Emeritus Plan dated March 20, 2001 Incorporated by reference to the  Company’s Quarterly Report on Form 10-Q for the period ended  June 30, 2002, filed with the Commission on August 14, 2002.                                             |

 

(b) Reports on Form 8-K

 
| On  January 25, 2008 the Company issued a press release announcing earnings  for the fourth quarter and year ending December 31, 2007.                                                                                       |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                   |
| On  March 7, 2008 the company issued a press release announcing the payment  of an eight cent dividend to shareholders of record as of March 31,  2008. The payment date for the dividend was April 25, 2008.           |
|                                                                                                                                                                                                                                   |
| On  April 18, 2006 the Company issued a press release announcing earnings  for the first quarter of 2008.                                                                                                                         |
|                                                                                                                                                                                                                                   |
| On  June 27, 2008 the Company issued a press release announcing the payment  of a four cent dividend to shareholders of record as of July 8, 2008.  The payment date for the dividend was July 25, 2008.                |
|                                                                                                                                                                                                                                   |
| On  July 18, 2008 the Company issued a press release announcing second  quarter 2008 earnings.                                                                                                                                    |
|                                                                                                                                                                                                                                   |
| On  September 19, 2008 the Company issued a press release announcing the  payment of a four cent dividend to shareholders of record as of  September 30, 2008. The payment date for the dividend was  October 24, 2008. |
|                                                                                                                                                                                                                                   |
| On  October 24, 2008 the Company issued a press release announcing third  quarter 2008 earnings.                                                                                                                                  |

 

59

----

Tableof Contents

 

**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of theSecurities and Exchange Act of 1934, the Registrant has duly caused this reportto be signed on its behalf by the undersigned thereunto duly authorized.

 
| Dated: March 30, 2009 | **COMMUNITY VALLEY BANCORP** |
|----------------------------|------------------------------|
|                       | a California corporation     |
|                       |                         |
|                       | By                           | */s/ Keith C. Robbins* |
|                       |                         | Keith C. Robbins |
|                       |                         | President and Chief Executive Officer |
|                       |                         |
|                       | By                           | */s/ John F. Coger* |
|                       |                         | John F. Coger |
|                       |                         | Executive Vice President  Chief Financial Officer and  Chief Operating Officer |

 

Pursuant to the requirements of the Securities Exchange Act of 1934,this report has been signed below by the following persons on behalf of theregistrant and in the capacities and on the dates indicated.

 
| **Signature**           | ** ** | **Title**                                        | ** ** | **Date**             |
|-------------------------|------------|--------------------------------------------------|------------|----------------------|
|                    |       |                                             |       |                 |
| */s/ M. Robert Ching*   |       | Director                                         |       | March 30,  2009 |
| M.  Robert Ching        |       |                                             |       |                 |
|                    |       |                                             |       |                 |
| */s/ John F. Coger*     |       | Executive  Vice President, CFO/COO and Director  |       | March 30,  2009 |
| John  F. Coger          |       |                                             |       |                 |
|                    |       |                                             |       |                 |
| */s/Eugene B. Even*     |       | Director                                         |       | March 30,  2009 |
| Eugene  B. Even         |       |                                             |       |                 |
|                    |       |                                             |       |                 |
| */s/ John D. Lanam*     |       | Director                                         |       | March 30,  2009 |
| John  D. Lanam          |       |                                             |       |                 |
|                    |       |                                             |       |                 |
| */s/ Donald W. Leforce* |       | Chairman  of the Board                           |       | March 30,  2009 |
| Donald  W. Leforce      |       |                                             |       |                 |
|                    |       |                                             |       |                 |
| */s/ Ellis L. Matthews* |       | Director                                         |       | March 30,  2009 |
| Ellis  L. Matthews      |       |                                             |       |                 |
|                    |       |                                             |       |                 |
| */s/ Luther McLaughlin* |       | Director  and Vice Chairman                      |       | March 30,  2009 |
| Luther  McLaughlin      |       |                                             |       |                 |
|                    |       |                                             |       |                 |
| */s/ Robert L. Morgan*  |       | Director                                         |       | March 30,  2009 |
| Robert  L. Morgan       |       |                                             |       |                 |
|                    |       |                                             |       |                 |
| */s/ Keith C. Robbins*  |       | President,  Chief Executive Officer and Director |       | March 30,  2009 |
| Keith  C. Robbins       |       |                                             |       |                 |
|                    |       |                                             |       |                 |
| */s/ James S. Rickards* |       | Director  and Corporate Secretary                |       | March 30,  2009 |
| James  S. Rickards      |       |                                             |       |                 |
|                    |       |                                             |       |                 |
| */s/ Gary B. Strauss*   |       | Director                                         |       | March 30,  2009 |
| Gary  B. Strauss        |       |                                             |       |                 |
|                    |       |                                             |       |                 |
| */s/ Hubert Townshend*  |       | Director                                         |       | March 30,  2009 |
| Hubert  Townshend       |       |                                             |       |                 |

** **

**60**

----

**Table of Contents**

** **

**COMMUNITY VALLEY BANCORP AND SUBSIDIARIES**

** **

**CONSOLIDATED FINANCIAL STATEMENTS**

 

**AS OF DECEMBER 31, 2008 AND 2007**

 

**AND FOR THE YEARS ENDED**

 

**DECEMBER 31, 2008, 2007 AND 2006**

 

**AND**

 

**REPORT OF INDEPENDENT REGISTERED**

 

**PUBLIC ACCOUNTING FIRM**

 

61

----

Tableof Contents

 

**REPORT OFMANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING**

 

Under the supervision and with the participation of our management,including our Chief Executive Officer and Chief Financial Officer, we conductedan evaluation of our disclosure controls and procedures, as such term isdefined under Rules 13a-15(f) and 15d-15(f) under the Exchange Act.  Based on this evaluation, our Chief ExecutiveOfficer and Chief Financial Officer concluded that our disclosure controls andprocedures were effective as of December 31, 2008.

 

Management is responsible for establishing and maintaining adequateinternal control over financial reporting at the Company.  Or internal control over financial reportingis a process designed under the supervision of the Chief Executive Office andChief Financial Officer to provide reasonable assurance regarding thereliability of financial reporting and preparation of the Company’s financialstatements for external reporting purposes in accordance with accountingprinciples generally accepted in the United States of America.  A company’s internal control over financialreporting includes policies and procedures that (1) pertain to themaintenance of records that accurately and fairly reflect, in reasonabledetail, transactions and dispositions of the company’s assets, (2) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with accounting principlesgenerally accepted in the United States of America and that receipts andexpenditures are being made only in accordance with authorizations ofmanagement and the directors of the company; and (3) provide reasonableassurance regarding prevention or timely detection of unauthorized acquisition,use, or disposition of the company’s assets that could have a material effecton the company’s financial statements.

 

Because of its inherent limitations, internal control over financialreporting may not prevent or detect misstatements.  Also, projections of any evaluation ofeffectiveness to future periods are subject to risk that controls may becomeinadequate because of changes in conditions, or that the degree of compliancewith the policies or procedures may deteriorate.

 

As of December 31, 2008, the Company carried out an evaluation,under the supervision and with the participation of the Company’s management,including the Company’s Chief Executive Officer and Chief Financial Officer, ofthe effectiveness of the Company’s internal control over financial reportingpursuant to Rule 13a-15(c), as adopted by the SEC under the ExchangeAct.  In evaluating the effectiveness ofthe Company’s internal control over financial reporting, management used theframework established in “*InternalControl—Integrated Framework*,” issued by the Committee of SponsoringOrganizations of the Treadway Commission (‘COSO).

 

Based on this evaluation, management concluded that as of December 31,2008, the Company’s internal control over financial reporting was effective.

 

 
| /s/  Keith C Robbins                |   |
|-------------------------------------|--------|
| Keith  C. Robbins                   |   |
| President,  Chief Executive Officer |   |
|                                |   |
| /s/  John F Coger                   |   |
| John  F. Coger                      |   |
| Executive  Vice President, CFO/COO  |   |
|                                |   |
| March 30, 2009                 |   |

 

62

----

Tableof Contents

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

The Board of Directors and Shareholders

Community Valley Bancorp

 

We have audited the accompanying consolidated balance sheet ofCommunity Valley Bancorp and subsidiaries as of December 31, 2008 and2007, and the related consolidated statements of income, changes inshareholders’ equity and cash flows for each of the years in the three-yearperiod ended December 31, 2008. These consolidated financial statementsare the responsibility of the Company’s management. Our responsibility is toexpress an opinion on these consolidated financial statements based on ouraudits.

 

We conducted our audits in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audits to obtain reasonable assurance aboutwhether the consolidated financial statements are free of material misstatement.An audit includes examining, on a test basis, evidence supporting the amountsand disclosures in the financial statements. An audit also includes assessingthe accounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to abovepresent fairly, in all material respects, the consolidated financial positionof Community Valley Bancorp and subsidiaries as of December 31, 2008 and2007 and the consolidated results of their operations and their cash flows foreach of the years in the three-year period ended December 31, 2008, inconformity with accounting principles generally accepted in the United Statesof America.

 

 
|                   | /s/ Perry-Smith LLP |
|------------------------|---------------------|
|                   |                |
| Sacramento, California |                |
| March 23, 2009    |                |

 

63

----

Tableof Contents

 

**COMMUNITYVALLEY BANCORP AND SUBSIDIARIES**

 

**CONSOLIDATEDBALANCE SHEET**

 

**December 31,2008 and 2007**

 
| ** **                                                                                                                                                               | ** ** | **2008**    | ** **  | **2007**    | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|-------------|-------------|------------|
| **ASSETS**                                                                                                                                                               |       |        |        |        |       |
|                                                                                                                                                                     |       |        |        |        |       |
| Cash and due from banks                                                                                                                                                  |       | $           | 21,743,000  |        | $          | 31,714,000 |   |
| Federal funds sold and other                                                                                                                                             |       | 36,605,000  |        | 54,290,000  |       |
| Total cash & cash equivalents                                                                                                                                   |       | 58,348,000  |        | 86,004,000  |       |
|                                                                                                                                                                     |       |        |        |        |       |
| Interest-bearing deposits in banks                                                                                                                                       |       | 2,576,000   |        | 4,250,000   |       |
| Loans held for sale at lower of cost or  market                                                                                                                          |       | 320,000     |        | —      |       |
| Investment Securities                                                                                                                                                    |       |        |        |        |       |
| Available-for-sale, at fair value                                                                                                                                        |       | 6,462,000   |        | 4,668,000   |       |
| Held-to-maturity, at cost                                                                                                                                                |       | 634,000     |        | 1,596,000   |       |
| Loans, less allowance for loan losses of  $7,826,000 at December 31, 2008 and $5,232,000 at December 31, 2007                                                  |       | 486,522,000 |        | 441,350,000 |       |
| Premises and equipment, net                                                                                                                                              |       | 7,013,000   |        | 17,905,000  |       |
| Bank owned life insurance                                                                                                                                                |       | 11,199,000  |        | 10,201,000  |       |
| Accrued interest receivable and other  assets                                                                                                                            |       | 22,170,000  |        | 14,646,000  |       |
| Total assets                                                                                                                                                             |       | $           | 595,244,000 |        | $          | 580,620,000 |   |
|                                                                                                                                                                     |       |        |        |        |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                           |       |        |        |        |       |
|                                                                                                                                                                     |       |        |        |        |       |
| Deposits:                                                                                                                                                                |       |        |        |        |       |
| Non-interest bearing                                                                                                                                                     |       | $           | 82,159,000  |        | $          | 77,574,000 |   |
| Interest bearing                                                                                                                                                         |       | 444,326,000 |        | 423,417,000 |       |
| Total deposits                                                                                                                                                           |       | 526,485,000 |        | 500,991,000 |       |
|                                                                                                                                                                     |       |        |        |        |       |
| ESOP and other notes payable                                                                                                                                             |       | 5,054,000   |        | 1,093,000   |       |
| Junior subordinated debentures                                                                                                                                           |       | 8,248,000   |        | 16,496,000  |       |
| Accrued interest payable and other  liabilities                                                                                                                          |       | 15,318,000  |        | 11,066,000  |       |
| Total liabilities                                                                                                                                                        |       | $           | 555,105,000 |        | $          | 529,646,000 |   |
|                                                                                                                                                                     |       |        |        |        |       |
| Commitments and contingencies (Note 10)                                                                                                                                  |       |        |        |        |       |
|                                                                                                                                                                     |       |        |        |        |       |
| Shareholders’ equity                                                                                                                                                |       |        |        |        |       |
| Common stock - no par value; 20,000,000  shares authorized; issued and outstanding - 6,699,553 shares at December 31,  2008 and 7,607,908 at December 31, 2007 |       | 10,147,000  |        | 10,910,000  |       |
|                                                                                                                                                                     |       |        |        |        |       |
| Unallocated ESOP shares 124,207 shares at  December 31, 2008 and 126,590 shares at December 31, 2007 (at cost)                                                 |       | (1,438,000  | )           | (1,407,000  | )          |
| Retained earnings                                                                                                                                                        |       | 31,416,000  |        | 41,454,000  |       |
| Accumulated other comprehensive income, net  of taxes                                                                                                                    |       | 14,000      |        | 17,000      |       |
|                                                                                                                                                                     |       |        |        |        |       |
| Total shareholders’ equity                                                                                                                                          |       | 40,139,000  |        | 50,974,000  |       |
| Total liabilities and shareholders’ equity                                                                                                                          |       | $           | 595,244,000 |        | $          | 580,620,000 |   |

 

The accompanying notes are an integralpart of these consolidated financial statements.

 

64

----

Tableof Contents

 

**COMMUNITY VALLEY BANCORP AND SUBSIDIARIES**

 

**CONSOLIDATEDSTATEMENT OF INCOME**

 

**For the Years Ended December 31, 2008,2007 and 2006**

 
| ** **                                            | ** ** | **2008**   | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|-------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Interest income:                                 |       |       |       |       |       |       |       |
| Interest and fees on loans                            |       | $          | 35,849,000 |       | $          | 40,272,000 |       | $ | 39,544,000 |   |
| Interest on Federal funds sold and other              |       | 602,000    |       | 2,475,000  |       | 846,000    |       |
| Interest on deposits in banks                         |       | 389,000    |       | 182,000    |       | 178,000    |       |
| Interest on investment securities:                    |       |       |       |       |       |       |       |
| Taxable                                               |       | 410,000    |       | 229,000    |       | 181,000    |       |
| Exempt from Federal income tax                        |       | 65,000     |       | 65,000     |       | 65,000     |       |
| Total interest income                                 |       | 37,315,000 |       | 43,223,000 |       | 40,814,000 |       |
|                                                  |       |       |       |       |       |       |       |
| Interest expense:                                     |       |       |       |       |       |       |       |
| Interest expense on deposits                          |       | 9,595,000  |       | 12,771,000 |       | 8,708,000  |       |
| Interest expense on junior subordinated  debentures   |       | 566,000    |       | 1,024,000  |       | 733,000    |       |
| Interest expense on notes payable                     |       | 204,000    |       | 94,000     |       | 91,000     |       |
| Total interest expense                                |       | 10,365,000 |       | 13,889,000 |       | 9,532,000  |       |
| Net interest income before provision for  loan losses |       | 26,950,000 |       | 29,334,000 |       | 31,282,000 |       |
| Provision for loan losses                             |       | 3,742,000  |       | (16,000    | )          | 638,000    |       |
| Net interest income after provision for  loan losses  |       | 23,208,000 |       | 29,350,000 |       | 30,644,000 |       |
|                                                  |       |       |       |       |       |       |       |
| Non-interest income:                                  |       |       |       |       |       |       |       |
| Service charges and fees                              |       | 3,904,000  |       | 3,422,000  |       | 2,686,000  |       |
| Gain on sale of loans                                 |       | 1,102,000  |       | 1,506,000  |       | 1,578,000  |       |
| Loan servicing income                                 |       | 556,000    |       | 395,000    |       | 457,000    |       |
| Other                                                 |       | 3,377,000  |       | 3,152,000  |       | 2,048,000  |       |
| Total non-interest income:                            |       | 8,939,000  |       | 8,475,000  |       | 6,769,000  |       |
|                                                  |       |       |       |       |       |       |       |
| Non-interest expenses:                                |       |       |       |       |       |       |       |
| Salaries and employee benefits                        |       | 14,585,000 |       | 15,630,000 |       | 15,425,000 |       |
| Occupancy and equipment                               |       | 5,425,000  |       | 4,221,000  |       | 3,480,000  |       |
| Impairment recognized on investment  security         |       | 1,489,000  |       | —     |       | —     |       |
| Other                                                 |       | 6,777,000  |       | 7,076,000  |       | 6,255,000  |       |
| Total non-interest expense                            |       | 28,276,000 |       | 26,927,000 |       | 25,160,000 |       |
|                                                  |       |       |       |       |       |       |       |
| Income before provision for income taxes              |       | 3,871,000  |       | 10,898,000 |       | 12,253,000 |       |
|                                                  |       |       |       |       |       |       |       |
| Provision for income taxes                            |       | 1,132,000  |       | 4,439,000  |       | 5,102,000  |       |
|                                                  |       |       |       |       |       |       |       |
| Net income                                            |       | $          | 2,739,000  |       | $          | 6,459,000  |       | $ | 7,151,000 |   |
|                                                  |       |       |       |       |       |       |       |
| Basic earnings per share                              |       | $          | 0.39       |       | $          | 0.87       |       | $ | 0.98 |   |
| Diluted earnings per share                            |       | $          | 0.39       |       | $          | 0.85       |       | $ | 0.93 |   |
|                                                  |       |       |       |       |       |       |       |
| Cash dividends per share                              |       | $          | 0.16       |       | $          | 0.32       |       | $ | 0.26 |   |

 

The accompanying notes are an integralpart of these consolidated financial statements.

 

65

----

#### Table of Contents

 

#### COMMUNITY VALLEY BANCORP AND SUBSIDIARIES

####  

**CONSOLIDATEDSTATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY**

 

**For the Years Ended December 31, 2008,2007 and 2006**

 
| ** **                                                                           | ** ** | **Common Stock** | ** ** | **Unallocated** | ** ** | **Retained **   | ** ** | **Accumulated**

**Other  Comprehensive** | ** ** | **Total  Shareholders’** | ** ** | **Comprehensive** | ** ** |
|--------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------|------------|----------------------|------------|-------------------------------------------|------------|-------------------------------|------------|-------------------|------------|
| ** **                                                                           | ** ** | **Shares**            | ** ** | **Amount**      | ** ** | **ESOP shares** | ** ** | **Earnings**                              | ** ** | **Income / (Loss)** | ** ** | **Equity**        | ** ** | **Income** | ** ** |
| Balance, January 1, 2006                                                             |       | 7,408,047             |       | $               | 9,051,000  |                 | $          | (1,391,000                                | )          | $                             | 33,908,000 |              | $          | (13,000 | ) | $ | 41,555,000 |   |   |   |
|                                                                                 |       |                  |       |            |       |                 |       |                                      |       |                          |       |              |       |   |   |
| Comprehensive income                                                                 |       |                  |       |            |       |                 |       |                                      |       |                          |       |              |       |   |   |
| Net income                                                                           |       |                  |       |            |       |                 |       | 7,151,000                                 |       |                          |       | 7,151,000         |       | $ | 7,151,000 |   |
| Other comprehensive income:                                                          |       |                  |       |            |       |                 |       |                                      |       |                          |       |              |       |   |   |
| Net change in unrealized gains (losses) on  available-for-sale investment securities |       |                  |       |            |       |                 |       |                                      |       | 22,000                        |       | 22,000            |       | 22,000 |   |
| Total comprehensive income                                                           |       |                  |       |            |       |                 |       |                                      |       |                          |       |              |       | $ | 7,173,000 |   |
|                                                                                 |       |                  |       |            |       |                 |       |                                      |       |                          |       |              |       |   |   |
| Exercise of stock options and related tax  benefit                                   |       | 130,567               |       | 1,000,000       |       |                 |       |                                      |       |                          |       | 1,000,000         |       |   |   |
| Amortization of stock compensation - ESOP  shares                                    |       |                  |       | 378,000         |       | 231,000              |       |                                      |       |                          |       | 609,000           |       |   |   |
| Shares acquired or redeemed by ESOP                                                  |       |                  |       |            |       | (354,000             | )          |                                      |       |                          |       | (354,000          | )          |   |   |
| Cash dividends- $.26 per share                                                       |       |                  |       |            |       |                 |       | (1,933,000                                | )          |                          |       | (1,933,000        | )          |   |   |
| Stock based compensation expense                                                     |       |                  |       | 175,000         |       |                 |       |                                      |       |                          |       | 175,000           |       |   |   |
| Repurchase and retirement of common stock                                            |       | (143,950              | )          | (877,000        | )          |                 |       | (1,621,000                                | )          |                          |       | (2,498,000        | )          |   |   |
| Balance, December 31, 2006                                                           |       | 7,394,664             |       | 9,727,000       |       | (1,514,000           | )          | 37,505,000                                |       | 9,000                         |       | 45,727,000        |       |   |   |
|                                                                                 |       |                  |       |            |       |                 |       |                                      |       |                          |       |              |       |   |   |
| Comprehensive income                                                                 |       |                  |       |            |       |                 |       |                                      |       |                          |       |              |       |   |   |
| Net income                                                                           |       |                  |       |            |       |                 |       | 6,459,000                                 |       |                          |       | 6,459,000         |       | $ | 6,459,000 |   |
| Other comprehensive income:                                                          |       |                  |       |            |       |                 |       |                                      |       |                          |       |              |       |   |   |
| Net change in unrealized gains on  available-for-sale investment securities          |       |                  |       |            |       |                 |       |                                      |       | 8,000                         |       | 8,000             |       | 8,000 |   |
| Total comprehensive income                                                           |       |                  |       |            |       |                 |       |                                      |       |                          |       |              |       | $ | 6,467,000 |   |
|                                                                                 |       |                  |       |            |       |                 |       |                                      |       |                          |       |              |       |   |   |
| Exercise of stock options and related tax  benefit                                   |       | 232,108               |       | 1,104,000       |       |                 |       |                                      |       |                          |       | 1,104,000         |       |   |   |
| Amortization of stock compensation– ESOP  shares                                |       |                  |       | 65,000          |       | 107,000              |       |                                      |       |                          |       | 172,000           |       |   |   |
| Cash dividends- $.32 per share                                                       |       |                  |       |            |       |                 |       | (2,425,000                                | )          |                          |       | (2,425,000        | )          |   |   |
| Stock based compensation expense                                                     |       |                  |       | 139,000         |       |                 |       |                                      |       |                          |       | 139,000           |       |   |   |
| Repurchase and retirement of common stock                                            |       | (18,864               | )          | (125,000        | )          |                 |       | (85,000                                   | )          |                          |       | (210,000          | )          |   |   |
| Balance, December 31, 2007                                                           |       | 7,607,908             |       | 10,910,000      |       | (1,407,000           | )          | 41,454,000                                |       | 17,000                        |       | 50,974,000        |       |   |   |
|                                                                                      |            |                       |            |                 |            |                      |            |                                           |            |                               |            |                   |            |  |  |  |  |  |  |  |  |

 

(Continued)

 

66

----

#### Table of Contents

 

#### COMMUNITY VALLEY BANCORP AND SUBSIDIARIES

####  

**CONSOLIDATED STATEMENT OF CHANGES INSHAREHOLDERS’ EQUITY**

 

**For the Years Ended December 31, 2008,2007 and 2006**

 
| ** **                                                                  | ** ** | **Common Stock** | ** ** | **Unallocated** | ** ** | **Retained **   | ** ** | **Accumulated**

**Other  Comprehensive** | ** ** | **Total  Shareholders’** | ** ** | **Comprehensive** | ** ** |
|-----------------------------------------------------------------------------|------------|-----------------------|------------|-----------------|------------|----------------------|------------|-------------------------------------------|------------|-------------------------------|------------|-------------------|------------|
| ** **                                                                  | ** ** | **Shares**            | ** ** | **Amount**      | ** ** | **ESOP shares** | ** ** | **Earnings**                              | ** ** | **Income / (Loss)** | ** ** | **Equity**        | ** ** | **Income** | ** ** |
| Balance, December 31, 2007                                                  |       | 7,607,908             |       | 10,910,000      |       | (1,407,000           | )          | 41,454,000                                |       | 17,000                        |       | 50,974,000        |       |   |   |
|                                                                        |       |                  |       |            |       |                 |       |                                      |       |                          |       |              |       |   |   |
| Comprehensive income                                                        |       |                  |       |            |       |                 |       |                                      |       |                          |       |              |       |   |   |
| Net income                                                                  |       |                  |       |            |       |                 |       | 2,739,000                                 |       |                          |       | 2,739,000         |       | $ | 2,739,000 |   |
| Other comprehensive income                                                  |       |                  |       |            |       |                 |       |                                      |       |                          |       |              |       |   |   |
| Net change in unrealized gains on  available-for-sale investment securities |       |                  |       |            |       |                 |       |                                      |       | (3,000                        | )          | (3,000            | )          | (3,000 | ) |
| Total comprehensive income                                                  |       |                  |       |            |       |                 |       |                                      |       |                          |       |              |       | $ | 2,736,000 |   |
|                                                                        |       |                  |       |            |       |                 |       |                                      |       |                          |       |              |       |   |   |
| Exercise of stock options and related tax  benefit                          |       | 103,651               |       | 654,000         |       |                 |       |                                      |       |                          |       | 654,000           |       |   |   |
| Amortization of stock compensation – ESOP  shares                      |       |                  |       | (8,000          | )          | 90,000               |       |                                      |       |                          |       | 82,000            |       |   |   |
| Shares acquired or redeemed by ESOP                                         |       |                  |       |            |       | (121,000             | )          |                                      |       |                          |       | (121,000          | )          |   |   |
| Cash dividends- $.16 per share                                              |       |                  |       |            |       |                 |       | (1,148,000                                | )          |                          |       | (1,148,000        | )          |   |   |
| Stock based compensation expense                                            |       |                  |       | 80,000          |       |                 |       |                                      |       |                          |       | 80,000            |       |   |   |
| Repurchase and retirement of common stock                                   |       | (1,012,006            | )          | (1,489,000      | )          |                 |       | (11,629,000                               | )          |                          |       | (13,118,000       | )          |   |   |
|                                                                        |       |                  |       |            |       |                 |       |                                      |       |                          |       |              |       |   |   |
| Balance, December 31, 2008                                                  |       | 6,699,553             |       | $               | 10,147,000 |                 | $          | (1,438,000                                | )          | $                             | 31,416,000 |              | $          | 14,000 |   | $ | 40,139,000 |   |   |   |
|                                                                             |            |                       |            |                 |            |                      |            |                                           |            |                               |            |                   |            |  |  |  |  |  |  |  |  |

 

The accompanying notes are an integralpart of these consolidated financial statements.

 

67

----

Table of Contents

 

**COMMUNITY VALLEY BANCORP AND SUBSIDIARIES**

 

**CONSOLIDATEDSTATEMENT OF CASH FLOWS**

 

**For the Years Ended December 31, 2008,2007 and 2006**

 
| ** **                                                                         | ** ** | **2008**    | ** ** | **2007**   | ** ** | **2006**    | ** ** |
|------------------------------------------------------------------------------------|------------|-------------|------------|------------|------------|-------------|------------|
|                                                                               |       |        |       |       |       |        |       |
| Cash flows from operating activities:                                              |       |        |       |       |       |        |       |
| Net income                                                                         |       | $           | 2,739,000  |       | $          | 6,459,000   |       | $ | 7,151,000 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |        |       |       |       |        |       |
| Provision for loan losses                                                          |       | 3,742,000   |       | (16,000    | )          | 638,000     |       |
| Decrease in deferred loan origination costs                                        |       | (210,000    | )          | (113,000   | )          | (307,000    | )          |
| Depreciation, amortization, and accretion,  net                                    |       | 2,081,000   |       | 2,100,000  |       | 1,671,000   |       |
| Increase in cash surrender value of  bank-owned life insurance, net                |       | (564,000    | )          | (383,000   | )          | (331,000    | )          |
| Non-cash compensation expense associated  with the ESOP                            |       | 82,000      |       | 172,000    |       | 609,000     |       |
| Stock based compensation                                                           |       | 80,000      |       | 139,000    |       | 175,000     |       |
| Excess tax benefit from exercise of  stock-based compensation awards               |       | (166,000    | )          | (428,000   | )          | (489,000    | )          |
| Impairment recognized on investment  security                                      |       | 1,489,000   |       | —     |       | —      |       |
| (Gain) loss on disposition of Bank premises  and equipment                         |       | (9,000      | )          | 28,000     |       | —      |       |
| Net (increase) decrease in loans held for  sale                                    |       | (320,000    | )          | 790,000    |       | 1,407,000   |       |
| (Increase) decrease in accrued interest  receivable and other assets               |       | (771,000    | )          | (1,805,000 | )          | 94,000      |       |
| Increase in accrued interest payable and  other liabilities                        |       | 4,862,000   |       | 1,060,000  |       | 519,000     |       |
| Provision for deferred income taxes                                                |       | (4,448,000  | )          | (612,000   | )          | (1,050,000  | )          |
| Net cash provided by operating activities                                          |       | 8,587,000   |       | 7,391,000  |       | 10,087,000  |       |
|                                                                               |       |        |       |       |       |        |       |
| Cash flows from investing activities:                                              |       |        |       |       |       |        |       |
| Purchase of held-to-maturity investment securities                                 |       | (1,750,000  | )          | —     |       | —      |       |
| Purchase of available-for-sale investment securities                               |       | (6,007,000  | )          | (3,437,000 | )          | —      |       |
| Proceeds from matured or called  available-for-sale investment securities          |       | 4,000,000   |       | 2,000,000  |       | 1,000,000   |       |
| Proceeds from matured or called  held-to-maturity investment securities            |       | 1,000,000   |       | —     |       | 246,000     |       |
| Proceeds from principal payments on  available-for-sale investment securities      |       | 211,000     |       | 133,000    |       | 31,000      |       |
| Proceeds from principal payments on  held-to-maturity investment securities        |       | 223,000     |       | 175,000    |       | 300,000     |       |
| Net decrease (increase) in interest-bearing  deposits in banks                     |       | 1,674,000   |       | (1,972,000 | )          | 4,358,000   |       |
| Net (increase) decrease in loans                                                   |       | (50,842,000 | )          | 1,030,000  |       | (41,361,000 | )          |
| Premiums paid for life insurance policies                                          |       | (434,000    | )          | (20,000    | )          | (1,020,000  | )          |
| Purchases of premises and equipment                                                |       | (900,000    | )          | (4,712,000 | )          | (5,820,000  | )          |
| Proceeds from sale of premises and  equipment                                      |       | 9,717,000   |       | 43,000     |       | 20,000      |       |
| Net cash used in investing activities                                              |       | (43,108,000 | )          | (6,760,000 | )          | (42,246,000 | )          |
|                                                                                    |            |             |            |            |            |             |            |  |  |  |

 

(Continued)

 

68

----

Tableof Contents

 

**COMMUNITY VALLEY BANCORP AND SUBSIDIARIES**

 

**CONSOLIDATEDSTATEMENT OF CASH FLOWS**

 

**For the Years Ended December 31, 2008,2007 and 2006**

 
| Cash flows from financing activities:                                                   |   |        |       |        |   |       |   |
|-----------------------------------------------------------------------------------------|--------|-------------|------------|-------------|--------|------------|--------|
| Net (decrease) increase in demand, interest-bearing  and savings deposits               |   | (1,902,000  | )          | 27,408,000  |   | 2,597,000  |   |
| Net increase (decrease) in time deposits                                                |   | 27,396,000  |       | (11,273,000 | )      | 48,241,000 |   |
| Proceeds (repayment) from notes payable,  net                                           |   | 3,961,000   |       | (124,000    | )      | (565,000   | )      |
| Purchase of unallocated ESOP shares                                                     |   | (121,000    | )          | —      |   | (354,000   | )      |
| Proceeds from exercise of stock options,  including tax benefit                         |   | 654,000     |       | 1,104,000   |   | 1,000,000  |   |
| Payment of cash dividends                                                               |   | (1,757,000  | )          | (2,408,000  | )      | (1,637,000 | )      |
| Repurchase and retirement of common stock                                               |   | (13,118,000 | )          | (210,000    | )      | (2,498,000 | )      |
| (Repayment) proceeds from issuance of  junior subordinated debentures                   |   | (8,248,000  | )          | 8,248,000   |   | —     |   |
| Net cash provided by financing activities                                               |   | 6,865,000   |       | 22,745,000  |   | 46,784,000 |   |
|                                                                                    |   |        |       |        |   |       |   |
| (Decrease) increase in cash and cash  equivalents                                       |   | (27,656,000 | )          | 23,376,000  |   | 14,625,000 |   |
|                                                                                    |   |        |       |        |   |       |   |
| Cash and cash equivalents at beginning of  year                                         |   | 86,004,000  |       | 62,628,000  |   | 48,003,000 |   |
|                                                                                    |   |        |       |        |   |       |   |
| Cash and cash equivalents at end of period                                              |   | $           | 58,348,000 |        | $      | 86,004,000 |   | $ | 62,628,000 |   |
|                                                                                    |   |        |       |        |   |       |   |
| Supplemental disclosure of cash flow  information:                                      |   |        |       |        |   |       |   |
|                                                                                    |   |        |       |        |   |       |   |
| Cash paid during the year for:                                                          |   |        |       |        |   |       |   |
| Interest                                                                                |   | $           | 10,705,000 |        | $      | 13,940,000 |   | $ | 9,147,000 |   |
| Income taxes                                                                            |   | $           | 5,830,000  |        | $      | 4,665,000  |   | $ | 6,064,000 |   |
|                                                                                    |   |        |       |        |   |       |   |
| Non-cash investing activities:                                                          |   |        |       |        |   |       |   |
| Real Estate Acquired through foreclosure                                                |   | $           | 2,068,000  |        | $      | —     |   | $ | — |   |
| Net change in unrealized gains on  available-for-sale investment securities, net of tax |   | $           | (3,000     | )           | $      | 8,000      |   | $ | 22,000 |   |
|                                                                                    |   |        |       |        |   |       |   |
| Non-cash financing activities:                                                          |   |        |       |        |   |       |   |
| Release of unallocated ESOP shares                                                      |   | $           | 90,000     |        | $      | 107,000    |   | $ | 231,000 |   |
| Accrual of cash dividend declared                                                       |   | $           | —     |        | $      | 609,000    |   | $ | 592,000 |   |
| Excess tax benefit from exercise of  stock-based compensation awards                    |   | $           | 166,000    |        | $      | 428,000    |   | $ | 489,000 |   |

 

The accompanying notes are an integralpart of these consolidated financial statements.

 

69

----

Tableof Contents

 

##### COMMUNITY VALLEY BANCORP AND SUBSIDIARIES

#####  

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**1.****                                      SUMMARYOF SIGNIFICANT ACCOUNTING POLICIES**

 

General

 

In May 2002, Community Valley Bancorp (“CommunityValley”) was incorporated as a bank holding company for the purpose ofacquiring Butte Community Bank (the “Bank”) in a one bank holding companyreorganization. In 2004, Community Valley changed its status to a FinancialHolding Company for the purpose of establishing Butte Community InsuranceAgency LLC (“BCBIA”). The new corporate structure gives Community Valley, theBank and BCBIA greater flexibility in terms of operation, expansion anddiversification.

 

Founded in 1990, the Bank is astate-chartered financial institution with fifteen branches in eleven citiesincluding Anderson, Chico, Colusa, Corning, Magalia, Marysville, Oroville,Paradise, Redding, Red Bluff, and Yuba City and loan production offices inCitrus Heights and Gridley. The Bank provides traditional deposit and lendingservices including commercial and construction loans, government guaranteedloans such as those available from the USDA and SBA, merchant services andinvestment services.

 

On July 10, 2007 Community Valley formeda wholly-owned subsidiary, Community Valley Bancorp Trust II (the “Trust”),which is a Delaware statutory business trust, for the purpose of issuing trustpreferred securities. The proceeds from the Trust were used to redeem 100% ofthe trust preferred securities issued by the 2002 Community Valley BancorpTrust I.  After redemption CommunityValley Trust I was dissolved (see Note 9).

 

On December 1, 2004, Community Valleyformed a wholly-owned subsidiary, Butte Community Insurance Agency LLC for thepurpose of providing insurance related services.

 

The deposits in the Bank are insured by theFederal Depository Insurance Corporation (“FDIC”) up to applicable legallimits.  The Bank is participating in theFDIC Transaction Account Guarantee Program. Under that program, through December 31, 2009, allnoninterest-bearing transaction accounts are fully guaranteed by the FDIC forthe entire amount in the account. Coverage under the Transaction Account Guarantee Program is in additionto and separate from the coverage available under the FDIC’s general depositinsurance rules.

 

The accounting and reporting policies ofCommunity Valley Bancorp and its subsidiaries (collectively, the “Company”)conform with accounting principles generally accepted in the United Statesof America and prevailing practice within the banking industry. The moresignificant of these policies applied in the preparation of the accompanyingconsolidated financial statements are discussed below.

 

Segment Information

 

Management has determined that since all ofthe banking products and services offered by the Company are available in eachbranch of the Bank, all branches are located within the same economicenvironment and management does not allocate resources based on the performanceof different lending or transaction activities, it is appropriate to aggregatethe Bank branches and report them as a single operating segment. No customeraccounts for more than 10 percent of revenues for the Company or the Bank.

 

Principles of Consolidation

 

The accompanying consolidated financialstatements include the accounts of Community Valley and its wholly-ownedsubsidiaries, Butte Community Bank and Butte Community Insurance Agency LLC.Significant intercompany transactions and balances have been eliminated in consolidation.

 

For financial reporting purposes, the Company’sinvestment in the Trust of $248,000 (see Note 9) is accounted for under theequity method and is included in accrued interest receivable and other assetson the consolidated balance sheet. The junior subordinated debentures issuedand guaranteed by the Company and held by the Trusts are reflected as debt inthe Company’s consolidated balance sheet.

 

Reclassifications

 

Certain reclassifications have been made toprior years’ balances to conform to classifications used in 2008.

 

70

----

Tableof Contents

 

Use of Estimates

 

The preparation of financial statements inconformity with accounting principles generally accepted in the United Statesof America requires management to make estimates and assumptions. Theseestimates and assumptions affect the reported amounts of assets and liabilitiesat the date of the financial statements and the reported amounts of revenuesand expenses during the reporting period. Actual results could differ fromthese estimates.

 

Cash and Cash Equivalents

 

For purposes of the consolidated statement ofcash flows, cash and cash equivalents include cash and due from banks andFederal funds sold and other interest-bearing deposits in banks with maturitiesof less than 90 days at acquisition. Federal funds are generally sold for one-day periods.

 

Investment Securities

 

Investmentsecurities are classified into the following categories:

 

·                                          Available-for-salesecurities, reported at fair value, with unrealized gains and losses excludedfrom earnings and reported, net of taxes, as accumulated other comprehensiveincome (loss) within shareholders’ equity.

 

·                                          Held-to-maturitysecurities, which management has the positive intent and ability to hold,reported at amortized cost, adjusted for the accretion of discounts andamortization of premiums.

 

Management determines the appropriateclassification of its investments at the time of purchase and may onlychange the classification in certain limited circumstances. All transfersbetween categories are accounted for at fair value. As of December 31,2008 and 2007 the Company did not have any investment securities classified astrading and there were no transfers of securities between categories.

 

Gains or losses on the sale of investmentsecurities are computed using the specific identification method. Interestearned on investment securities is reported in interest income, net ofapplicable adjustments for accretion of discounts and amortization of premiums.

 

Investment securities are evaluated for impairment on at least aquarterly basis and more frequently when economic or market conditions warrantsuch an evaluation to determine whether a decline in their value is other thantemporary. Management utilizes criteria such as the magnitude and duration ofthe decline and the intent and ability of the Company to retain its investmentin the issues for a period of time sufficient to allow for an anticipatedrecovery in fair value, in addition to the reasons underlying the decline, todetermine whether the loss in value is other than temporary. The term “otherthan temporary” is not intended to indicate that the decline is permanent, butindicates that the prospects for a near-term recovery of value is notnecessarily favorable, or that there is a lack of evidence to support arealizable value equal to or greater than the carrying value of the investment.Once a decline in value is determined to be other than temporary, the value ofthe security is reduced and a corresponding charge to earnings is recognized.

 

Loans

 

Loans are stated at principal balances outstanding, except for loanstransferred from loans held for sale which are carried at the lower ofprincipal balance or market value at the date of transfer, adjusted foraccretion of discounts. Interest is accrued daily based upon outstanding loanbalances. However, when, in the opinion of management, loans are considered tobe impaired and the future collectibility of interest and principal is inserious doubt, loans are placed on nonaccrual status and the accrual ofinterest income is suspended. Any interest accrued but unpaid is chargedagainst income. Payments received are applied to reduce principal to the extentnecessary to ensure collection. Subsequent payments on these loans, or paymentsreceived on nonaccrual loans for which the ultimate collectibility of principalis not in doubt, are applied first to earned but unpaid interest and then toprincipal.

 

A loan is considered impaired when, based on current information andevents, it is probable that the Company will be unable to collect all amountsdue (including both principal and interest) in accordance with the contractual termsof the loan agreement. An impaired loan is measured based on the present valueof expected future cash flows discounted at the loan’s effective interest rateor, as a practical matter, at the loan’s observable market price or the fairvalue of collateral if the loan is collateral dependent. Interest income onimpaired loans, if appropriate, is recognized on a cash basis.

 

Substantially all loan origination fees, commitment fees, direct loanorigination costs and purchase premiums and discounts on loans are deferred andrecognized as an adjustment of yield, to be amortized to interest income overthe contractual term of the loan. The unamortized balance of deferred fees andcosts is reported as a component of net loans.

 

71

----

Tableof Contents

 

The Company may acquire loans through a business combination or apurchase for which differences may exist between the contractual cashflows and the cash flows expected to be collected due, at least in part, tocredit quality. When the Company acquires such loans, the yield thatmay be accreted (accretable yield) is limited to the excess of the Company’sestimate of undiscounted cash flows expected to be collected over the Company’sinitial investment in the loan. The excess of contractual cash flows over cashflows expected to be collected may not be recognized as an adjustment toyield, loss, or a valuation allowance. Subsequent increases in cash flowsexpected to be collected generally should be recognized prospectively throughadjustment of the loan’s yield over its remaining life. Decreases in cash flowsexpected to be collected should be recognized as an impairment. The Companymay not “carry over” or create a valuation allowance in the initialaccounting for loans acquired under these circumstances. At December 31,2008 and 2007, there were no such loans being accounted for under this policy.

 

Loans Held for Sale, Loan Sales and ServicingRights

 

The Company accounts for the transfer andservicing of financial assets based on the financial and servicing assets itcontrols and liabilities it has incurred, derecognizes financial assets whencontrol has been surrendered, and derecognizes liabilities when extinguished.

 

Servicing rights acquired through 1) apurchase or 2) the origination of loans which are sold with servicing rightsretained are recognized as separate assets or liabilities. Servicing assets orliabilities are recorded at the difference between the contractual servicingfees and adequate compensation for performing the servicing, and aresubsequently amortized in proportion to and over the period of the related netservicing income or expense. Servicing assets are periodically evaluated forimpairment. Fair values are estimated using discounted cash flows based oncurrent market interest rates. For purposes of measuring impairment, servicingassets are stratified based on note rate and term. The amount of impairmentrecognized, if any, is the amount by which the servicing assets for a stratumexceed their fair value.

 

Any servicing assets in excess of thecontractually specified servicing fees have been reclassified at fair value asan interest-only (IO) strip receivable and treated like an available-for-salesecurity. The servicing asset, net of any required valuation allowance, and IOstrip receivable are included in accrued interest and other assets. At December 31,2008 and 2007, IO strips were not significant.

 

*GovernmentGuaranteed Loans*

 

Included in the loan portfolio are loanswhich are 80% to 90% guaranteed by the Small Business Administration (SBA),U.S. Department of Agriculture, Rural Business — Cooperative Service (RBS) andFarm Services Agency (FSA). The guaranteed portion of these loans may besold to a third party, with the Company retaining the unguaranteed portion. TheCompany generally receives a premium in excess of the adjusted carrying valueof the loan at the time of sale. The Company may be required to refund a portionof the sales premium if the borrower defaults or the loan prepays within ninetydays of the settlement date.

 

The Company’s investment in the loan isallocated between the retained portion of the loan, the servicing asset, the IOstrip, and the sold portion of the loan based on their relative fair values onthe date the loan is sold. The gain on the sold portion of the loan isrecognized as income at the time of sale. The carrying value of the retainedportion of the loan is discounted based on the estimated value of a comparablenon-guaranteed loan. The servicing asset and IO strip is recognized asdiscussed above. Significant future prepayments of these loans will result inthe recognition of additional amortization of related servicing assets and anadjustment to the carrying value of related IO strips.

 

The Company serviced SBA, RBS and FSAgovernment guaranteed loans for others totaling $114,460,000 and $100,822,000as of December 31, 2008 and 2007, respectively.

 

*MortgageLoans*

 

The Companyoriginates mortgage loans that are either held in the Company’s loan portfolioor sold in the secondary market. Loans held for sale are carried at the lowerof cost or market value. Market value is determined by the specificidentification method as of the balance sheet date or the date which thepurchasers have committed to purchase the loans. At the time the loan is sold,the related right to service the loan is either retained, with the Companyrecognizing the servicing asset, or released in exchange for a one-timeservicing-released premium. Loans subsequently transferred to the loanportfolio are transferred at the lower of cost or market value at the date of 

 

72

----

Table of Contents

 

transfer. Anydifference between the carrying amount of the loan and its outstandingprincipal balance is recognized as an adjustment to yield by the interestmethod.

 

The Company serviced loans for the FederalNational Mortgage Association (FNMA) totaling $9,308,000 as of December 31,2008.  In September 2007 the Companysold the servicing rights for this portfolio of loans and continued tooriginate and sell mortgage loans with servicing released through the remainderof 2007.

 

*Participation Loans*

 

The Company also serviced loans which it hasparticipated with other financial institutions totaling $2,622,000 and$5,543,000 as of December 31, 2008 and 2007, respectively.

 

## Allowance for Loan Losses

##  

The allowance for loan losses is maintainedto provide for losses related to impaired loans and other losses that can bereasonably expected to occur in the normal course of business. Thedetermination of the allowance for loan losses is based on estimates made by managementto include consideration of the character of the loan portfolio, specificallyidentified problem loans, potential losses inherent in the portfolio taken as awhole and economic conditions in the Company’s service area.

 

Classifiedloans and loans determined to be impaired are evaluated by management forspecific risk of loss. In addition, a reserve factor is assigned to currentlyperforming loans based on management’s assessment of the following for eachidentified loan type: (1) inherent credit risk, (2) historical lossesand, (3) where the Company has not experienced losses, the loss experienceof peer banks. These estimates are particularly susceptible to changes in theeconomic environment and market conditions.

 

The Company’s Board of Directors reviews theadequacy of the allowance for loan losses at least quarterly, to include considerationof the relative risks in the portfolio and current economic conditions. Theallowance for loan losses is adjusted based on that review if, in the judgmentof the Board of Directors and management, changes are warranted.

 

The allowance for loan losses is establishedthrough a provision for loan losses which is charged to expense. Additions tothe allowance for loan losses are expected to maintain the adequacy of thetotal allowance after loan losses and loan growth. The allowance for loanlosses at December 31, 2008 and 2007 reflects management’s estimate ofpossible losses in the portfolio.

 

##### **Allowance for Losses Related to UndisbursedLoan Commitments**

#####  

The Company maintains a separate allowancefor losses related to undisbursed loan commitments. Management estimates theamount of probable losses by applying the loss factors used in the allowancefor loan loss methodology to an estimate of the expected usage and applies thefactor to the unused portion of undisbursed lines of credit. The allowancetotaled $293,000 and $860,000 at December 31, 2008 and 2007, respectively,and is included in accrued interest payable and other liabilities on thebalance sheet.

 

## Other Real Estate

##  

The Company’s investment in other realestate, all of which were related to real estate acquired in full or partialsettlement of loan obligations, was $2,068,000 at December 31, 2008.  The Company did not have any other realestate at December 31, 2007.  Therewere no sales of other real estate in 2008 or 2007. When property is acquired,any excess of the Company’s recorded investment in the loan balance and accruedinterest income over the estimated fair market value of the property less estimatedcosts to sell is charged against the allowance for loan losses and the otherreal estate is included as part of the accrued interest receivable and otherassets in the accompanying consolidated balance sheet. When appropriate, avaluation allowance for losses on other real estate is maintained to providefor temporary declines in value. Subsequent gains or losses on sales or write-downs resulting fromfurther impairment are recorded in other income or expenses as incurred.

 

Premises and Equipment

 

Premises and equipment are carried at cost.Depreciation is determined using the straight-line method over the estimateduseful lives of the related assets. The useful lives of premises are estimatedto be thirty to thirty-nine years. Leasehold improvements are amortized overthe life of the improvement or the life of the related lease, whichever isshorter. The useful lives of furniture, fixtures and equipment are estimated tobe three to ten years. When assets are sold or otherwise disposed of, the cost andrelated accumulated depreciation are removed from the accounts, and anyresulting gain or loss is recognized in income for the period. The cost ofmaintenance and repairs is charged to expense as incurred.

 

73

----

Tableof Contents

 

The Company evaluates premises and equipmentfor financial impairment as events or changes in circumstances indicate thatthe carrying amount of such assets may not be fully recoverable.

 

Income Taxes

 

The Companyfiles its income taxes on a consolidated basis with its subsidiaries. Theallocation of income tax expense (benefit) represents each entity’sproportionate share of the consolidated provision for income taxes.

 

The Companyaccounts for income taxes using the liability or balance sheet method. Underthis method, deferred tax assets and liabilities are recognized for the taxconsequences of temporary differences between the reported amounts of assetsand liabilities and their tax bases. Deferred tax assets and liabilities areadjusted for the effects of changes in tax laws and rates on the date ofenactment. On the consolidated balance sheet, net deferred tax assets areincluded in accrued interest receivable and other assets.

 

Since January 1, 2007, the Company hasaccounted for uncertainty in income taxes under Financial Accounting StandardsBoard (“FASB”) Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes* (“FIN 48”).  Under the provisions of FIN 48 only taxpositions that met the more-likely-than-not recognition threshold on January 1,2007 were recognized or continue to be recognized.  The Company previously recognized income taxpositions based on management’s estimate of whether it was reasonably possiblethat a liability had been incurred for unrecognized income tax benefits byapplying FASB Statement No. 5, *Accountingfor Contingencies*.  Theadoption of FIN 48 did not have a material impact on the Company’sfinancial position, results of operations or cash flows.

 

When tax returns are filed, it is highly certain that some positionstaken would be sustained upon examination by the taxing authorities, whileothers are subject to uncertainty about the merits of the position taken or theamount of the position that would be ultimately sustained.  The benefit of a tax position is recognizedin the financial statements in the period during which, based on all availableevidence, management believes it is more likely than not that the position willbe sustained upon examination, including the resolution of appeals orlitigation processes, if any.  Tax positions taken are not offset oraggregated with other positions.  Taxpositions that meet the more-likely-than-not recognition threshold are measuredas the largest amount of tax benefit that is more than 50 percent likely ofbeing realized upon settlement with the applicable taxing authority.  The portion of the benefits associated withtax positions taken that exceeds the amount measured as described above isreflected as a liability for unrecognized tax benefits in the accompanyingbalance sheet along with any associated interest and penalties that would bepayable to the taxing authorities upon examination.

 

Interest expense and penalties associated with unrecognized taxbenefits, if any, are classified as income tax expense in the consolidatedstatement of income.

 

Earnings Per Share

 

Basic earnings per share (EPS), whichexcludes dilution, is computed by dividing income available to common shareholdersby the weighted-average number of common shares outstanding for the period,excluding the effect of unallocated shares of the Employee Stock OwnershipPlan.  Diluted EPS reflects the potentialdilution that could occur if securities or other contracts to issue commonstock, such as stock options, result in the issuance of common stock whichshares in the earnings of the Company. The treasury stock method has been applied to determine the dilutiveeffect of stock options in computing diluted EPS.

 

Comprehensive Income

 

Comprehensive income is a more inclusivefinancial reporting methodology that includes disclosure of other comprehensiveincome (loss) that historically has not been recognized in the calculation ofnet income. Unrealized gains or losses on the Company’s available-for-saleinvestment securities and IO strip are the principle source of othercomprehensive income or loss. Total comprehensive income and the components ofaccumulated other comprehensive income (loss) are presented in the consolidatedstatement of changes in shareholders’ equity.

 

74

----

Tableof Contents

 

Stock-Based Compensation

 

The Company issues stock options under two shareholder approvedstock-based compensation plans, the Community Valley Bancorp 1997 and 2000Stock Option Plans.  The Plans do notprovide for the settlement of awards in cash and new shares are issued uponexercise of the options.  The plansrequire that the option price may not be less than the fair market value of thestock at the date the option is granted, and that the stock must be paid for infull at the time the option is exercised. The options expire on a datedetermined by the Board of Directors, but not later than ten years from thedate of grant. The vesting period is determined by the Board of Directors andis generally over five years; however, nonstatutory options granted during 1997vested immediately. Under the 1997 plan, 8,254 shares of common stock remainreserved for issuance to employees and directors, and the related options areexercisable until their expiration. However, no new options will be grantedunder this plan. Under the Company’s 2000 stock option plan, 341,977 shares ofcommon stock remain reserved for issuance to employees and directors, of which96,916 shares are available for future grants.

 

Management estimates the fair value of each option award as of the dateof the grant using a Black-Sholes-Merton option pricing model.  Expected volatility is based on historicalvolatility of the Company’s stock over a preceding period commensurate with theexpected term of the option.  The “simplified”method described in SEC Staff Accounting Bulletin No. 107, as amended bySEC Staff Accounting Bulletin 110, was used to determine the expected term ofthe Company’s options for 2008 and 2007. The risk free interest rate for the expected term of the option is basedon U.S. Treasury yield curve in effect at the time of the grant.  The expected dividends yield was determinedbased on the budgeted cash dividends of the Company at the time of thegrant.  In addition to these assumptions,management makes estimates regarding pre-vesting forfeitures that will impacttotal compensation expense recognized under the Plan.

 

The fair valueof each option is estimated on the date of grant using the followingassumptions.  No options were grantedduring 2008.

 
| ** **                                                      | ** ** | **2007**  | ** ** | **2006**  | ** ** |
|-----------------------------------------------------------------|------------|-----------|------------|-----------|------------|
|                                                            |       |      |       |      |       |
| Expected volatility                                             |       | 46.85     | %          | 11.54     | %          |
| Risk-free interest rate                                         |       | 4.5       | %          | 4.6       | %          |
| Expected option life                                            |       | 7.5 years |       | 7.5 years |       |
| Expected dividend yield                                         |       | 2.70      | %          | 1.47      | %          |
| Weighted average fair value of options  granted during the year |       | $         | 6.02       |      | $          | 3.75 |   |
|                                                                 |            |           |            |           |            |  |  |

 

Impact of New Financial Accounting Standards

 

*Accounting for Business Combinations*

 

In December 2007, the FASB issuedStatement of Financial Accounting Standards No. 141 (revised 2007), *Business Combinations*(“SFAS No. 141R”).  SFAS No. 141(R), among other things,establishes principles and requirements for how the acquirer in a businesscombination (i) recognizes and measures in its financial statements theidentifiable assets acquired, the liabilities assumed, and any noncontrollinginterest in the acquired business, (ii) recognizes and measures thegoodwill acquired in the business combination or a gain from a bargainpurchase, and (iii) determines what information to disclose to enableusers of the financial statements to evaluate the nature and financial effectsof the business combination.  The Companyis required to adopt SFAS No. 141(R) for all business combinationsfor which the acquisition date is on or after January 1, 2009.  Earlier adoption is prohibited.  This standard will change the accountingtreatment for business combinations on a prospective basis.

 

*The Hierarchy of Generally AcceptedAccounting Principles*

 

In May 2008, the FASB issued SFAS No. 162,*The Hierarchy of Generally Accepted AccountingPrinciples*(SFAS No. 162). This standard identifies the sourcesof accounting principles and the framework for selecting the principles to beused in the preparation of financial statements of nongovernmental entitiesthat are presented in conformity with accounting principles generally acceptedin the United States of America (GAAP). It establishes that the GAAP hierarchyshould be directed to entities because it is the entity (not the auditor) thatis responsible for selecting accounting principles for financial statementsthat are presented in conformity with GAAP. SFAS 162 was effective November 15,2008.  The adoption of this Statement didnot have any effect on the Company’s consolidated financial statements.

 

75

----

Tableof Contents

 

**2.****                                      INVESTMENTSECURITIES**

 

The amortizedcost and estimated fair value of investment securities at December 31,2008 and 2007 consisted of the following:

 
| ** **                                        | ** ** | **2008**            | ** ** |
|---------------------------------------------------|------------|---------------------|------------|
| **Available for Sale**                  | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** |
| ** **                                        | ** ** | ** **          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Debt securities:                                  |       |                |       |   |   |   |   |   |   |
| U.S. Government agencies                          |       | $                   | 5,080,000  |   | $ | 24,000 |   | $ | (10,000 | ) | $ | 5,094,000 |   |
| Obligations of states and political  subdivisions |       | 1,358,000           |       | 16,000 |   | (6,000 | ) | 1,368,000 |   |
|                                              |       | $                   | 6,438,000  |   | $ | 40,000 |   | $ | (16,000 | ) | $ | 6,462,000 |   |
|                                              |       |                |       |   |   |   |   |   |   |
| ** **                                        | ** ** | **2007**            | ** ** |
| ** **                                        | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** |
| ** **                                        | ** ** | ** **          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Debt securities:                                  |       |                |       |   |   |   |   |   |   |
| U.S. Government agencies                          |       | $                   | 3,282,000  |   | $ | 17,000 |   | $ | (12,000 | ) | $ | 3,287,000 |   |
| Obligations of states and political  subdivisions |       | 1,357,000           |       | 24,000 |   | — |   | 1,381,000 |   |
|                                              |       | $                   | 4,639,000  |   | $ | 41,000 |   | $ | (12,000 | ) | $ | 4,668,000 |   |

 

Net unrealized gains on available-for-saleinvestment securities totaling $24,000 and $29,000 were recorded, net of $10,000 and $12,000 in tax expenses,respectively, as accumulated other comprehensive  income within shareholders’ equity at December 31,2008 and 2007, respectively. There were no sales or transfers ofavailable-for-sale investment securities for the years ended December 31,2008, 2007 and 2006.

 

During its assessment of the investmentportfolio for other-than-temporary impairment of investment securities,management considers many factors.  Incases where a security is of a type for which there is very little activetrading, if any, management must consider other factors when conducting itsevaluation.  As of December 31,2008, the Company held one such security, a trust preferred security.  Although all scheduled interest payments havebeen received through December 31, 2008, management considered otherfactors and made certain assumptions in reaching its conclusion.  Such factors and assumptions includedindependent indications of the fair value of the security, adverse conditionsrelated to the financial industry in general, the financial condition of theissuer, and certain assumptions regarding the impact of past events, currentconditions and the likelihood of future events and the timing of cash flows,including any recoveries. After giving consideration to all the above factors,management concluded that an other-than-temporary impairment had occurred andrecorded a $1,489,000 impairment charge through earnings on this trustpreferred security with an original par value of $1,750,000.

 

76

----

Table of Contents

 
| ** **                     | ** ** | **2008**            | ** ** |
|--------------------------------|------------|---------------------|------------|
| **Held to Maturity** | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** |
| ** **                     | ** ** | ** **          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Debt securities:               |       |                |       |   |   |   |   |   |   |
| U.S. Government agencies       |       | $                   | 373,000    |   | $ | 4,000 |   | $ | — |   | $ | 377,000 |   |
| Other securities               |       | 261,000             |       | — |   | — |   | 261,000 |   |
|                           |       | $                   | 634,000    |   | $ | 4,000 |   | $ | — |   | $ | 638,000 |   |
|                           |       |                |       |   |   |   |   |   |   |
| ** **                     | ** ** | **2007**            | ** ** |
| ** **                     | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Estimated  Fair Value** | ** ** |
| ** **                     | ** ** | ** **          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Debt securities:               |       |                |       |   |   |   |   |   |   |
| U.S. Government agencies       |       | $                   | 1,596,000  |   | $ | 7,000 |   | $ | (1,000 | ) | $ | 1,602,000 |   |

 

There were nosales or transfers of held-to-maturity investment securities for the yearsended December 31, 2008, 2007 and 2006.

 

Investment securities with unrealized lossesat December 31, 2008 and 2007 are summarized and classified according tothe duration of the loss period as follows:

 
| ** **                                       | ** ** | **2008**                               | ** ** |
|--------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                       | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **                                       | ** ** | **Fair Value**                    | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
|                                             |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| Debt securities:                                 |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| U.S. Government agencies                         |       | $                                      | —     |   | $ | — |   | $ | 686,000 |   | $ | (10,000 | ) | $ | 686,000 |   | $ | (10,000 | ) |
| Obligations of states and political subdivisions |       | $                                      | 657,000    |   | $ | (6,000 | ) | $ | — |   | $ | — |   | $ | 657,000 |   | $ | (6,000 | ) |
|                                             |       | $                                      | 657,000    |   | $ | (6,000 | ) | $ | 686,000 |   | $ | (10,000 | ) | $ | 1,343,000 |   | $ | (16,000 | ) |
|                                             |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| ** **                                       | ** ** | **2007**                               | ** ** |
| ** **                                       | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **                                       | ** ** | **Fair Value**                    | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** | **Fair Value** | ** ** | **Unrealized  Losses** | ** ** |
|                                             |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| Debt securities:                                 |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| U.S. Government agencies                         |       | $                                      | —     |   | $ | — |   | $ | 1,837,000 |   | $ | (12,000 | ) | $ | 1,837,000 |   | $ | (12,000 | ) |

 

At December 31, 2008, the Company heldeleven U.S. Government agency securities of which one was in a loss positionfor twelve months or more and held three obligations of state and politicalsubdivision securities of which one was in a loss position for less than 12months.  The unrealized losses on theCompany’s investments in direct obligations of U.S. government agencies andstate and political subdivisions were caused by interest rate changes.   The contractual terms of these investmentsdo not permit the issuer to settle the security at a price less than theamortized cost of the investment. Because the decline in market value is attributable to changes ininterest rates and not credit quality, and because the Company has the abilityand intent to hold this investment until a recovery of fair value, which may bematurity, the Company does not consider this investment to beother-than-temporarily impaired at December 31, 2008.

 

77

----

Tableof Contents

 

The amortizedcost and estimated fair value of investment securities at December 31,2008, by contractual maturity, are shown below. Expected maturities will differfrom contractual maturities because the issuers of securities may have theright to call or prepay obligations with or without prepayment penalties.

 
| ** **                                                | ** ** | **Available for Sale** | ** ** | **Held to Maturity** | ** ** |
|-----------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                | ** ** | **Amortized  Cost**              | ** ** | **Estimated  Fair Value** | ** ** | **Amortized  Cost** | ** ** | **Estimated  Fair Value** | ** ** |
|                                                      |       |                             |       |                           |       |   |   |   |   |
| Within one year                                           |       | $                                | —     |                           | $          | — |   | $ | — |   | $ | — |   |
| After one year through five years                         |       | 2,998,000                        |       | 3,014,000                      |       | — |   | — |   |
| After five years through ten years                        |       | 495,000                          |       | 498,000                        |       | — |   | — |   |
| After ten years                                           |       | 863,000                          |       | 870,000                        |       | 261,000 |   | 261,000 |   |
|                                                      |       |                             |       |                           |       |   |   |   |   |
|                                                      |       | 4,356,000                        |       | 4,382,000                      |       | 261,000 |   | 261,000 |   |
|                                                      |       |                             |       |                           |       |   |   |   |   |
| Investment securities not due at a single  maturity date: |       |                             |       |                           |       |   |   |   |   |
| SBA pools                                                 |       | 2,082,000                        |       | 2,080,000                      |       | 373,000 |   | 377,000 |   |
|                                                      |       |                             |       |                           |       |   |   |   |   |
|                                                      |       | $                                | 6,438,000  |                           | $          | 6,462,000 |   | $ | 634,000 |   | $ | 638,000 |   |

 

Investmentsecurities with amortized costs totaling $4,356,000 and $4,357,000 and fairvalues totaling $4,382,000 and $4,389,000 were pledged to secure publicdeposits and treasury, tax and loan accounts at December 31, 2008 and2007, respectively.

 

**3.             LOANS AND ALLOWANCEFOR LOAN LOSSES**

 

Outstandingloans are summarized as follows:

 
| ** **                | ** ** | **December 31,** | ** **  |
|---------------------------|------------|-----------------------|-------------|
| ** **                | ** ** | **2008**              | ** **  | **2007** | ** ** |
| Real estate:              |       |                  |        |   |   |
| Mortgage                  |       | $                     | 252,018,000 |   | $ | 207,590,000 |   |
| Construction              |       | 65,004,000            |        | 81,914,000 |   |
| Commercial                |       | 83,786,000            |        | 78,521,000 |   |
| Agriculture               |       | 28,628,000            |        | 26,347,000 |   |
| Installment               |       | 65,390,000            |        | 52,898,000 |   |
|                      |       |                  |        |   |   |
| Total loans               |       | 494,826,000           |        | 447,270,000 |   |
|                      |       |                  |        |   |   |
| Deferred loan fees, net   |       | (478,000              | )           | (688,000 | ) |
| Allowance for loan losses |       | (7,826,000            | )           | (5,232,000 | ) |
|                      |       |                  |        |   |   |
| Total net loans           |       | $                     | 486,522,000 |   | $ | 441,350,000 |   |

 

78

----

Tableof Contents

 

Changes in theallowance for loan losses were as follows:

 
| ** **                               | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------|------------|--------------------------------------------|------------|
| ** **                               | ** ** | **2008**                                   | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                               | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance, beginning of year               |       | $                                          | 5,232,000  |   | $ | 5,274,000 |   | $ | 4,716,000 |   |
| Provision charged/credited to operations |       | 3,742,000                                  |       | (16,000 | ) | 638,000 |   |
| Losses charged to allowance              |       | (1,158,000                                 | )          | (26,000 | ) | (82,000 | ) |
| Recoveries                               |       | 10,000                                     |       | — |   | 2,000 |   |
|                                     |       |                                       |       |   |   |   |   |
| Balance, end of year                     |       | $                                          | 7,826,000  |   | $ | 5,232,000 |   | $ | 5,274,000 |   |

 

At December 31,2008 and 2007, nonaccrual loans totaled $15,051,000 and $253,000, which wereconsidered impaired loans. A valuation allowance of $1,156,000 and $20,000 wasallocated to these loans in 2008 and 2007 respectively.  The average recorded investment in impairedloans for the years ended December 31, 2008 and 2007 was $5,355,000 and$110,000, respectively.  Interestforegone on nonaccrual loans totaled $262,000 for the year ended December 31,2008, $10,000 for 2007 and $106,000 for 2006. Interest recognized for cashpayment received on nonaccrual loans was not significant for the years ended December 31,2008, 2007 and 2006, respectively. Salaries and employee benefits totaling$852,000, $1,189,000 and $1,246,000 have been deferred as loan originationcosts for the years ended December 31, 2008, 2007 and 2006, respectively.

 

**4.****                                      ACCRUEDINTEREST RECEIVABLE AND OTHER ASSETS**

 

Accrued interest receivable and other assetsconsisted of the following:

 
| ** **                  | ** ** | **December 31,** | ** ** |
|-----------------------------|------------|-----------------------|------------|
| ** **                  | ** ** | **2008**              | ** ** | **2007** | ** ** |
|                        |       |                  |       |   |   |
| Accrued interest receivable |       | $                     | 3,838,000  |   | $ | 3,657,000 |   |
| Deferred tax assets, net    |       | 10,282,000            |       | 5,831,000 |   |
| Loan servicing assets       |       | 2,004,000             |       | 1,104,000 |   |
| Prepaid expenses            |       | 1,358,000             |       | 1,439,000 |   |
| Other Real Estate Owned     |       | 2,068,000             |       | — |   |
| Other                       |       | 2,620,000             |       | 2,615,000 |   |
|                        |       |                  |       |   |   |
|                        |       | $                     | 22,170,000 |   | $ | 14,646,000 |   |

 

Originated servicing assets totaling$900,000, $232,000 and $208,000 were recognized during the years ended December 31,2008, 2007 and 2006, respectively. Amortization of servicing assets totaled $337,000, $330,000 and $409,000for the years ended December 31, 2008, 2007 and 2006, respectively.  In the third quarter of 2007 the Company soldthe mortgage servicing rights for a one time pre tax gain of $730,000.

 

79

----

Tableof Contents

 

**5.****                                      PREMISESAND EQUIPMENT**

 

Premises andequipment consisted of the following:

 
| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2008**              | ** ** | **2007** | ** ** |
|                                            |       |                  |       |   |   |
| Land                                            |       | $                     | —     |   | $ | 2,176,000 |   |
| Buildings and improvements                      |       | 3,454,000             |       | 12,927,000 |   |
| Furniture, fixtures, and equipment              |       | 10,754,000            |       | 9,867,000 |   |
| Leasehold Improvements                          |       | 2,469,000             |       | 2,485,000 |   |
| Construction in progress                        |       | —                |       | 31,000 |   |
|                                            |       |                  |       |   |   |
|                                            |       | 16,677,000            |       | 27,486,000 |   |
|                                            |       |                  |       |   |   |
| Less accumulated depreciation and  amortization |       | 9,664,000             |       | 9,581,000 |   |
|                                            |       |                  |       |   |   |
|                                            |       | 7,013,000             |       | 17,905,000 |   |
|                                                 |            |                       |            |  |  |  |  |

 

Depreciation and amortization included inoccupancy and equipment expense totaled $2,084,000, $2,108,000 and $1,662,000for the years ended December 31, 2008, 2007 and 2006 respectively.

 

In February 2008,the Company sold and simultaneously entered into long-term operating leaseagreements on seven of its properties with proceeds from the sale totaling$15,300,000 and a net gain of $5,592,000 which is being deferred and recognizedover the 15 year term of the leases. Gains recognized included in other non-interest income totaled $326,000for the year ended December 31, 2008. Rent expenses recognized on theses leases was $1,156,000 for the yearended December 31, 2008.  Futureminimum lease payments on the leases for the next five years are estimated tobe $1,180,000 per year, see Note 10.

 

80

----

Tableof Contents

 

**6.****                                      INTEREST-BEARINGDEPOSITS**

 

Interest-bearingdeposits consisted of the following:

 
| ** **                     | ** ** | **December 31,** | ** **  |
|--------------------------------|------------|-----------------------|-------------|
| ** **                     | ** ** | **2008**              | ** **  | **2007** | ** ** |
|                           |       |                  |        |   |   |
| Savings                        |       | $                     | 107,129,000 |   | $ | 111,394,000 |   |
| Money market                   |       | 33,058,000            |        | 37,053,000 |   |
| NOW accounts                   |       | 116,224,000           |        | 115,436,000 |   |
| Individual retirement accounts |       | 8,918,000             |        | 7,933,000 |   |
| Time, $100,000 or more         |       | 101,222,000           |        | 79,606,000 |   |
| Other time                     |       | 77,775,000            |        | 71,995,000 |   |
|                           |       | $                     | 444,326,000 |   | $ | 423,417,000 |   |

 

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

 
| **Year Ending  December 31,** | ** ** | ** ** | ** **  |
|-----------------------------------------|------------|------------|-------------|
|                                    |       |       |        |
| 2009                                    |       | $          | 176,832,000 |   |
| 2010                                    |       | 7,083,000  |        |
| 2011                                    |       | 1,372,000  |        |
| 2012                                    |       | 1,869,000  |        |
| 2013                                    |       | 759,000    |        |
|                                    |       |       |        |
|                                    |       | $          | 187,915,000 |   |

 

Interest expense recognized oninterest-bearing deposits consisted of the following:

 
| ** **                     | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------|------------|--------------------------------------------|------------|
| ** **                     | ** ** | **2008**                                   | ** ** | **2007** | ** ** | **2006** | ** ** |
|                           |       |                                       |       |   |   |   |   |
| Savings                        |       | $                                          | 2,039,000  |   | $ | 3,567,000 |   | $ | 337,000 |   |
| Money market                   |       | 531,000                                    |       | 631,000 |   | 616,000 |   |
| NOW accounts                   |       | 634,000                                    |       | 919,000 |   | 1,210,000 |   |
| Individual retirement accounts |       | 298,000                                    |       | 343,000 |   | 242,000 |   |
| Time, $100,000 or more         |       | 3,407,000                                  |       | 3,729,000 |   | 3,061,000 |   |
| Other time                     |       | 2,686,000                                  |       | 3,582,000 |   | 3,242,000 |   |
|                           |       | $                                          | 9,595,000  |   | $ | 12,771,000 |   | $ | 8,708,000 |   |

 

**7.****                                      SHORT-TERMBORROWING ARRANGEMENTS**

 

The Companyhas $15,000,000 in unsecured borrowing arrangements with two of itscorrespondent banks to meet short-term liquidity needs. There were noborrowings outstanding under these arrangements at December 31, 2008 and2007.

 

**8.****                                      NOTESPAYABLE**

 

Employee Stock Ownership Plan (ESOP) Note

 

The ESOPobtained financing through a $1,300,000 unsecured line of credit from anotherfinancial institution with the Company acting as the guarantor (seeNote 15). The note has a variable interest rate, based on an independentindex, and a maturity date of April 10, 2014. At December 31, 2008,the interest rate was 5.75%. Advances on the line of credit totaled $1,054,000and $1,093,000 at December 31, 2008 and 2007 respectively.

 

81

----

Table of Contents

 

Line of Credit with Pacific Coast Bankers Bank

 

During 2008the Company obtained a Line of Credit in the amount of $4,000,000 from PacificCoast Bankers Bank.  The note has avariable interest rate, based on LIBOR plus 3.25% with a floor of 5.75%, and amaturity date of June 30, 2010. Quarterly payments are interest only. At December 31, 2008, the interest rate was 5.75%.  Advances on the line of credit totaled$4,000,000 at December 31, 2008.

 

**9.**                                      JUNIOR SUBORDINATED DEBENTURES

** **

Community Valley Bancorp Trust I and II (CVB Trust I and II) areDelaware statutory business trusts formed by the Company for the sole purposeof issuing trust preferred securities fully and unconditionally guaranteed bythe Company. Under applicable regulatory guidance, the amount of trustpreferred securities that is eligible as Tier 1 capital is limited totwenty-five percent of the Company’s Tier 1 capital on a pro forma basis. At December 31,2008, all of the trust preferred securities that have been issued qualify asTier 1 capital.

 

In December 2002, the Company issued toCVB Trust I Subordinated Debentures due December 31, 2032. Simultaneously,CVB Trust I issued 8,000 floating rate trust preferred securities, withliquidation values of $1,000 per security, for gross proceeds of $8,000,000.The Subordinated Debentures represent the sole assets of the Trust. TheSubordinated Debentures are redeemable by the Company, subject to certainrequirements.  On January 7, 2008the Company, having  met all of theredemption requirements, redeemed 100% of the Trust I Subordinated Debenturesprimarily through utilizing the proceeds from the issuance of the July 2007Trust II Subordinated Debentures and dissolved CVB Trust I.

 

 In July 2007,the Company issued to CVB Trust II Subordinated Debentures due October 1,2037. Simultaneously, CVB Trust II issued 8,000 fixed rate trust preferredsecurities, with liquidation values of $1,000 per security, for gross proceedsof $8,000,000. The Subordinated Debentures represent the sole assets of theTrust. The Subordinated Debentures are redeemable by the Company, subject toreceipt by the Company of prior approval from the Federal Reserve Bank (FRB),if then required under applicable capital guidelines or policies of the FRB.The Company may redeem the Subordinated Debentures held by CVB Trust II onany October 1st on or after October 1, 2012. The redemption priceshall be par plus accrued and unpaid interest, except in the case of redemptionunder a special event, which is defined in the debenture. The fixed rate trustpreferred securities are subject to mandatory redemption to the extent of anyearly redemption of the Subordinated Debentures and upon maturity of theSubordinated Debentures on October 1, 2037.

 

Holders of the trust preferred securities are entitledto cumulative cash distributions on the liquidation amount of $1,000 persecurity. Interest rates on the trust preferred securities and SubordinatedDebentures are the same and are computed on a 360-day basis. The statedinterest rate for the initial five year term of 7.14% was calculated on theclosing date of the transaction, July 10, 2007 using the three-monthLondon Interbank Offered Rate (LIBOR) plus 1.57%.  At the end of the initial five year periodthe rate will convert to a floating rate using the three-month LIBOR plus 1.57%for the remaining term.

 

Interest expense recognized by the Company for theyears ended December 31, 2008, 2007 and 2006 related to the subordinateddebentures was $566,000, $1,024,000 and $733,000 respectively. There were nodeferred costs at December 31, 2008 or 2007. The amortization of thedeferred costs was $48,000 for the year ended December 31, 2006.

 

82

----

Table of Contents

 

**10.****                               COMMITMENTSAND CONTINGENCIES**

 

Leases

 

The Company leases certain of its branchoffices and certain equipment under noncancellable operating leases. Theseleases expire on various dates through 2023 and have various renewal optionsranging from five to fifteen years. In February 2008, the Company sold andsimultaneously entered into long-term operating lease arrangements on seven ofits properties (see Note 5). Rental payments include minimum rentals, plusadjustments for changing price indexes. Future minimum lease payments andsublease rental income are as follows:

 
| **Year Ending  December 31,** | ** ** | **Minimum  Lease  Payments** | ** ** | **Minimum  Sublease  Rental  Income** | ** ** |
|-----------------------------------------|------------|------------------------------|------------|---------------------------------------|------------|
| ** **                              | ** ** | ** **                   | ** ** | ** **                            | ** ** |
| 2009                                    |       | $                            | 2,182,000  |                                  | $          | 338,000 |   |
| 2010                                    |       | 2,094,000                    |       | 323,000                               |       |
| 2011                                    |       | 2,030,000                    |       | 217,000                               |       |
| 2012                                    |       | 1,899,000                    |       | 113,000                               |       |
| 2013                                    |       | 1,760,000                    |       | 69,000                                |       |
| Thereafter                              |       | 16,108,000                   |       | 164,000                               |       |
|                                    |       |                         |       |                                  |       |
|                                    |       | $                            | 26,073,000 |                                  | $          | 1,224,000 |   |

 

Rental expense included in occupancy andequipment expense totaled $2,211,000, $1,027,000 and $753,000 for the yearsended December 31, 2008, 2007 and 2006, respectively. Sublease incomenetted against the occupancy expense totaled $373,000, $321,000 and $144,000for the years ended December 31, 2008, 2007 and 2006, respectively.

 

Financial Instruments With Off-Balance-SheetRisk

 

The Company isa party to financial instruments with off-balance-sheet risk in the normalcourse of business in order to meet the financing needs of its customers. Thesefinancial instruments include commitments to extend credit and standby lettersof credit. These instruments involve, to varying degrees, elements of creditand interest rate risk in excess of the amount recognized on the consolidatedbalance sheet.

 

The Company’s exposure to credit loss in theevent of nonperformance by the other party for commitments to extend credit andstandby letters of credit is represented by the contractual amount of thoseinstruments. The Company uses the same credit policies in making commitmentsand standby letters of credit as it does for loans included on the consolidatedbalance sheet.

 

The following financial instruments representoff-balance-sheet credit risk:

 
| ** **                   | ** ** | **December 31,** | ** **  |
|------------------------------|------------|-----------------------|-------------|
| ** **                   | ** ** | **2008**              | ** **  | **2007** | ** ** |
| ** **                   | ** ** | ** **            | ** **  | ** ** | ** ** |
| Commitments to extend credit |       | $                     | 147,614,000 |   | $ | 183,699,000 |   |
| Standby letters of credit    |       | $                     | 6,482,000   |   | $ | 6,695,000 |   |

 

Commitments toextend credit are agreements to lend to a customer as long as there is noviolation of any condition established in the contract. Commitments generallyhave fixed expiration dates or other termination clauses and may requirepayment of a fee. Since some of the commitments are expected to expire without beingdrawn upon, the total commitment amounts do not necessarily represent futurecash requirements. Each customer’s creditworthiness is evaluated on acase-by-case basis. The amount of collateral obtained, if deemed necessary uponextension of credit, is based on management’s credit evaluation of theborrower. Collateral held varies, but may include deposit accounts,accounts receivable, inventory, equipment and deeds of trust on residentialreal estate and income-producing commercial properties.

 

Standby letters of credit are conditionalcommitments issued to guarantee the performance of a customer to a third party.The credit risk involved in issuing standby letters of credit is essentiallythe same as that involved in extending loans to customers. The fair value ofthe liability related to these standby letters of credit, which represents thefees received for issuing the guarantees, was not significant at December 31,2008 and 2007. The Company recognizes these fees as revenues over the term ofthe commitment or when the commitment is used.

 

Commercial loan commitments and standbyletters of credit represent approximately 20% of total commitments and aregenerally unsecured or secured by collateral other than real estate and havevariable interest rates. Agricultural loan commitments represent approximately15% of total commitments and are generally secured by crop assignments,accounts receivable and farm equipment and have variable interest rates. Realestate loan commitments represent approximately 35% of total commitments andare generally secured by property with a loan-to-value ratio not to exceed 80%.The majority of real estate commitments also have variable interest rates.Personal lines of credit and home equity lines of credit represent theremaining 30% of total commitments and are generally unsecured or secured byresidential real estate and have both variable and fixed interest rates.

 

83

----

Tableof Contents

 

Concentrations of Credit Risk

 

The Company grants real estate mortgage, realestate construction, commercial, agricultural and consumer loans to customersthroughout Butte, Sutter, Yuba, Tehama, Shasta, Colusa and Placer Counties.

 

Although the Company has a diversified loanportfolio, a substantial portion of its portfolio is secured by commercial andresidential real estate. However, personal and business income represents theprimary source of repayment for a majority of these loans.

 

In addition, the Company’s real estate andconstruction loans represent approximately 64% and 65% of outstanding loans at December 31,2008, and 2007 respectively. Collateral values associated with this lendingconcentration can vary significantly based on the general level of interestrates and both local and regional economic conditions. A continued substantialdecline in the performance of the economy in general or a continued decline inreal estate values in the Company’s primary market areas, in particular, couldhave an adverse impact on the collectibility of these loans.

 

Correspondent Banking Agreements

 

The Company maintains funds on deposit withother federally insured financial institutions under correspondent bankingagreements. All of these deposits were non interest bearing and therefore wereinsured for their total amount through the Temporary Liquidity GuaranteeProgram enacted by the FDIC on November 21, 2008.

 

Federal Reserve Requirements

 

Banks are required to maintain reserves withthe Federal Reserve Bank equal to a percentage of their reservable depositsless vault cash. The Bank’s vault cash fulfilled its reserve requirement at December 31,2008.

 

Contingencies

 

The Company is subject to legal proceedingsand claims which arise in the ordinary course of business. In the opinion ofmanagement, the amount of ultimate liability with respect to such actions willnot materially affect the consolidated financial position or consolidatedresults of operations of the Company.

 

**11.****                               SHAREHOLDERS’EQUITY**

 

Dividends

 

The shareholders of theCompany will be entitled to receive dividends when and as declared by its Boardof Directors, out of funds legally available for the payment of dividends, asprovided in the California General Corporation Law. The California generalcorporation law prohibits the Company from paying dividends on its common stockunless: (i)its retained earnings, immediately prior to the dividend payment,equals or exceeds the amount of the dividend or (ii) immediately aftergiving effect to the dividend, the sum of the Company’s assets (exclusive ofgoodwill and deferred charges) would be at least equal to 125% of itsliabilities (not including deferred taxes, deferred income and other deferredliabilities) and the current assets of the Company would be at least equal toits current liabilities, or, if the average of its earnings before taxes onincome and before interest expense for the two preceding fiscal years was lessthan the average of its interest expense for the two preceding fiscal years, atleast equal to 125% of its current liabilities. In certain circumstances, theCompany may be required to obtain the prior approval of the FederalReserve Board to make capital distributions to shareholders of the Company.

 

The California Financial Code restricts thetotal dividend payment of any bank in any calendar year to the lesser of (1) thebank’s retained earnings or (2) the bank’s net income for its last threefiscal years, less distributions made to shareholders during the samethree-year period. At December 31, 2008, retained earnings of $9,561,000were free of such restrictions. In addition the Company’s ability to paydividends is subject to certain covenants contained in the indentures relatingto Trust Preferred Securities issued by CVB Trust II (see Note 9).

 

Stock Repurchase Plan

 

In March 2008, Community Valley Bancorp announced an offer topurchase up to 1,000,000 shares of its common stock at a purchase price of$13.00.  Based on the final count by thedepositary for the tender offer, shareholders properly tendered 1,572,907shares of its common stock.  The Board ofDirectors of Community Valley Bancorp elected to not exercise itsoversubscription privileges in the tender offer to purchase more than 1,000,000properly tendered shares and purchased a total of 999,939 shares for$12,999,000 at $13.00 per share representing a pro-rata share of the tenderedshares of 63.38%, on May 5, 2008.

 

84

----

Table of Contents

 

In 2007 the Board of Directors approved a plan to repurchase up to$6,000,000 of the outstanding common stock of the Company in 2007. Stockrepurchases were made from time to time on the open market or through privatelynegotiated transactions. The timing of purchases and the exact number of sharespurchased was dependent on market conditions. The share repurchase program didnot include specific price targets or timetables and could have beensuspended at any time by action of the Board of Directors. During 2008, 12,067shares were repurchased for $119,000 at an average price of $9.84 pershare.  During 2007, 18,864 shares wererepurchased for $210,000 at an average price of $11.15 per share.

 

In 2003 the Board of Directors approved aplan to repurchase up to $3,000,000 of the outstanding common stock of theCompany in 2003. Stock repurchases were made from time to time on the openmarket or through privately negotiated transactions. The timing of purchasesand the exact number of shares purchased was dependent on market conditions.The share repurchase program did not include specific price targets ortimetables and could have been suspended at any time. During 2006, 143,950shares were repurchased for $2,498,000 at an average price of $17.35 per share.There were no shares available for repurchase under this plan after December 31,2006.

 

85

----

Tableof Contents

 

Stock-Based Compensation

 

Stock option activity for the years ended December 31,2008, 2007 and 2006 is summarized as follows:

 
| ** **                            | ** ** | **2008**    | ** ** | **2007**                               | ** ** | **2006**    | ** ** |
|---------------------------------------|------------|-------------|------------|----------------------------------------|------------|-------------|------------|
| ** **                            | ** ** | **Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Incentive Options                     |       |        |       |                                   |       |        |       |   |   |   |   |   |   |
|                                  |       |        |       |                                   |       |        |       |   |   |   |   |   |   |
| Options outstanding beginning of year |       | 289,710     |       | 8.48                                   |       | 438,196     |       | 7.35 |   | 487,962 |   | 6.76 |   |
|                                  |       |        |       |                                   |       |        |       |   |   |   |   |   |   |
| Options granted                       |       | —      |       |                                   |       | 1,000       |       | 13.95 |   | 23,000 |   | 17.17 |   |
| Options exercised                     |       | (19,636     | )          | 4.69                                   |       | (138,332    | )          | 2.59 |   | (57,572 | ) | 4.90 |   |
| Options cancelled                     |       | (23,039     | )          | 13.17                                  |       | (11,154     | )          | 10.70 |   | (15,194 | ) | 12.49 |   |
|                                  |       |        |       |                                   |       |        |       |   |   |   |   |   |   |
| Options outstanding, end of year      |       | 247,035     |       | 9.61                                   |       | 289,710     |       | 8.48 |   | 438,196 |   | 7.35 |   |
|                                  |       |        |       |                                   |       |        |       |   |   |   |   |   |   |
| Options exercisable, end of year      |       | 213,699     |       | 8.78                                   |       | 229,240     |       | 8.28 |   | 336,818 |   | 5.65 |   |
|                                  |       |        |       |                                   |       |        |       |   |   |   |   |   |   |
| Non-Qualified Options                 |       |        |       |                                   |       |        |       |   |   |   |   |   |   |
|                                  |       |        |       |                                   |       |        |       |   |   |   |   |   |   |
| Options outstanding beginning of year |       | 187,211     |       | 4.44                                   |       | 280,987     |       | 4.44 |   | 353,982 |   | 4.17 |   |
|                                  |       |        |       |                                   |       |        |       |   |   |   |   |   |   |
| Options exercised                     |       | (84,015     | )          | 4.71                                   |       | (93,776     | )          | 3.39 |   | (72,995 | ) | 3.13 |   |
|                                  |       |        |       |                                   |       |        |       |   |   |   |   |   |   |
| Options outstanding, end of year      |       | 103,196     |       | 5.17                                   |       | 187,211     |       | 4.93 |   | 280,987 |   | 4.44 |   |
|                                  |       |        |       |                                   |       |        |       |   |   |   |   |   |   |
| Options exercisable, end of year      |       | 101,596     |       | 5.04                                   |       | 183,743     |       | 4.83 |   | 277,021 |   | 4.34 |   |

 

86

----

Tableof Contents

 

A summary of options outstanding at December 31,2008 follows:

 
| **Range of Exercise Prices** | ** ** | **Number of  Options  Outstanding  December 31,  2008** | ** ** | **Weighted  Average  Remaining  Contractual  Life** | ** ** | **Number of  Options  Exercisable  December 31,  2008** | ** ** | **Number of  Options  Expected to  Vest December  31, 2008** | ** ** |
|---------------------------------------------|------------|-------------------------------------------------------------------|------------|-----------------------------------------------------|------------|-------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| Incentive Options                           |       |                                                              |       |                                                |       |                                                              |       |                                                                             |       |
|                                        |       |                                                              |       |                                                |       |                                                              |       |                                                                             |       |
| $2.29 - $4.53                               |       | 4,738                                                             |       | 0.75 years                                          |       | 4,738                                                             |       | 4,738                                                                            |       |
| $4.54 - $7.12                               |       | 128,608                                                           |       | 3.23 years                                          |       | 128,608                                                           |       | 128,608                                                                          |       |
| $7.13 - $12.36                              |       | 8,025                                                             |       | 4.13 years                                          |       | 8,025                                                             |       | 8,025                                                                            |       |
| $12.37 - $13.99                             |       | 68,664                                                            |       | 5.93 years                                          |       | 54,328                                                            |       | 68,377                                                                           |       |
| $14.00 - $17.80                             |       | 37,000                                                            |       | 6.90 years                                          |       | 18,000                                                            |       | 36,620                                                                           |       |
|                                        |       | 247,035                                                           |       |                                                |       | 213,699                                                           |       | 246,368                                                                          |       |
|                                        |       |                                                              |       |                                                |       |                                                              |       |                                                                             |       |
| Non-qualified Options                       |       |                                                              |       |                                                |       |                                                              |       |                                                                             |       |
|                                        |       |                                                              |       |                                                |       |                                                              |       |                                                                             |       |
| $4.71                                       |       | 95,460                                                            |       | 1.33 years                                          |       | 95,460                                                            |       | 95,460                                                                           |       |
| $9.65                                       |       | 5,332                                                             |       | 4.80 years                                          |       | 5,332                                                             |       | 5,332                                                                            |       |
| $13.25                                      |       | 2,404                                                             |       | 6.19 years                                          |       | 804                                                               |       | 2,372                                                                            |       |
|                                        |       | 103,196                                                           |       |                                                |       | 101,596                                                           |       | 103,164                                                                          |       |

 

The weighted average grant date fair value of options granted duringthe years ended December 31, 2007 and 2006 was $6.02 and $3.75.  There were no options granted during 2008.

 

The aggregate intrinsic value is calculated as the difference betweenthe exercise price of the underlying awards and the quoted price of the Company’scommon stock for options that were in-the-money at December 31, 2008.There was no aggregate intrinsic value of options outstanding, no intrinsicvalue of options vested and no intrinsic value for options vested or expectedto vest for the year ended December 31, 2008.  The intrinsic value of options exercised forthe years ended December 31, 2008, 2007 and 2006 totaled ($47,000),$1,663,000 and $1,560,000 respectively.    The total fair value of the shares that vested during the years ended December 31,2008, 2007, and 2006 totaled $109,000, $535,000 and $175,000, respectively.

 

The compensation cost charged against income for stock options was$80,000, $139,000 and $175,000 for the years ended December 31, 2008,2007and 2006, respectively. Income tax benefits recognized for the years ended December 31,2008, 2007 and 2006 totaled $166,000 $428,000 and $489,000, respectively.Management’s estimate of expected forfeitures for the remaining non-vestedoptions is approximately 2% and is recognizing compensation costs only forthose equity awards expected to vest.

 

At December 31, 2008, the total compensation cost related tonon-vested stock option awards granted to employees under the Company’s stockoption plans but not yet recognized was $93,000. Stock option compensationexpense is recognized on a straight-line basis over the vesting period of theoption. This cost is expected to be recognized over a weighted averageremaining period of 2.0 years and will be adjusted for subsequent changes inestimated forfeitures.

 

SFAS 123(R) requires the cash flows resulting from the taxbenefits resulting from tax deductions in excess of the compensation costrecognized for those options (excess tax benefits) to be classified as a cashflow from financing activities in the consolidated statement of cash flows.These excess tax benefits for the year ending December 31, 2008, 2007and 2006 totaled $166,000, $428,000 and $489,000, respectively.

 

87

----

Tableof Contents

 

Earnings Per Share

 

A reconciliationof the numerators and denominators of the basic and diluted earnings per sharecomputations is as follows:

 
| **For the Year Ended** | ** ** | **Net Income** | ** ** | **Weighted  Average  Number of  Shares  Outstanding** | ** ** | **Per Share  Amount** | ** ** |
|---------------------------------------|------------|---------------------|------------|------------------------------------------------------------|------------|----------------------------|------------|
|                                  |       |                |       |                                                       |       |                       |       |
| December 31, 2008                |       |                |       |                                                       |       |                       |       |
|                                  |       |                |       |                                                       |       |                       |       |
| Basic earnings per share              |       | $                   | 2,739,000  |                                                       | 6,940,876  |                       | $          | 0.39 |   |
|                                  |       |                |       |                                                       |       |                       |       |
| Effect of dilutive stock options      |       |                |       | 67,962                                                     |       |                       |       |
|                                  |       |                |       |                                                       |       |                       |       |
| Diluted earnings per share            |       | $                   | 2,739,000  |                                                       | 7,008,838  |                       | $          | 0.39 |   |
|                                  |       |                |       |                                                       |       |                       |       |
| December 31, 2007                |       |                |       |                                                       |       |                       |       |
|                                  |       |                |       |                                                       |       |                       |       |
| Basic earnings per share              |       | $                   | 6,459,000  |                                                       | 7,416,874  |                       | $          | 0.87 |   |
|                                  |       |                |       |                                                       |       |                       |       |
| Effect of dilutive stock options      |       |                |       | 195,085                                                    |       |                       |       |
|                                  |       |                |       |                                                       |       |                       |       |
| Diluted earnings per share            |       | $                   | 6,459,000  |                                                       | 7,611,959  |                       | $          | 0.85 |   |
|                                  |       |                |       |                                                       |       |                       |       |
| December 31, 2006                |       |                |       |                                                       |       |                       |       |
|                                  |       |                |       |                                                       |       |                       |       |
| Basic earnings per share              |       | $                   | 7,151,000  |                                                       | 7,279,969  |                       | $          | 0.98 |   |
|                                  |       |                |       |                                                       |       |                       |       |
| Effect of dilutive stock options      |       |                |       | 381,076                                                    |       |                       |       |
|                                  |       |                |       |                                                       |       |                       |       |
| Diluted earnings per share            |       | $                   | 7,151,000  |                                                       | 7,661,045  |                       | $          | 0.93 |   |

 

Stock options totaling 122,000 and 118,000 were excluded from thecomputation of diluted earnings per share for the years ended December 31,2008 and December 31, 2007 respectively due to the stock options beingconsidered anti-dilutive.  All stockoptions outstanding were included in the computation of diluted earnings pershare for the year ended December 31, 2006 as none of those stock optionswere considered anti-dilutive.

 

Regulatory Capital

 

The Company and the Bank are subject tocertain regulatory capital requirements administered by the Board of Governorsof the Federal Reserve System and the FDIC. Failure to meet these minimumcapital requirements can initiate certain mandatory, and possibly additionaldiscretionary, actions by regulators that, if undertaken, could have a directmaterial effect on the Company’s consolidated financial statements. Undercapital adequacy guidelines, the Company and the Bank must meet specificcapital guidelines that involve quantitative measures of their assets,liabilities and certain off-balance sheet items as calculated under regulatoryaccounting practices.  These quantitativemeasures are established by regulation and require that minimum amounts andratios of total and Tier 1 capital to risk-weighted assets and of Tier1 capitalto average assets be maintained.  Capitalamounts and classifications are also subject to qualitative judgments by theregulators about components, risk weightings and other factors.

 

The Bank is alsosubject to additional capital guidelines under the regulatory framework forprompt corrective action.  To becategorized as well capitalized, the Bank must maintain total risk-based, Tier1 risk-based, and Tier 1 leverage ratios as set forth in the followingtable.  The most recent notification fromthe FDIC categorized the Bank as well capitalized under these guidelines.  There are no conditions or events since thatnotification that management believes have changed the Bank’s category.

 

88

----

Table of Contents

 

Managementbelieves the Company and the Bank meet all their capital adequacy requirementsas of December 31, 2008 and 2007. There are no conditions or events sincethose notifications that management believes have changed the categories.

 
| ** **                               | ** ** | **Actual** | ** ** | **For Capital Adequacy  Purposes** | ** ** | **To Be Well Capitalized  Under Prompt Corrective  Action Provisions** | ** ** |
|------------------------------------------|------------|------------|------------|----------------------------------------------|------------|------------------------------------------------------------------------------------------------------|------------|
| ** **                               | ** ** | **Amount** | ** ** | **Ratio**                                    | ** ** | **Minimum  Amount**                                                                                  | ** ** | **Minimum  Ratio** | ** ** | **Minimum  Amount** | ** ** | **Minimum  Ratio** | ** ** |
| ** **                               | ** ** | ** ** | ** ** | ** **                                   | ** ** | ** **                                                                                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| December 31, 2008                   |       |       |       |                                         |       |                                                                                                 |       |   |   |   |   |   |   |
|                                     |       |       |       |                                         |       |                                                                                                 |       |   |   |   |   |   |   |
| Company:                                 |       |       |       |                                         |       |                                                                                                 |       |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)  |       | $          | 53,668,000 |                                         | 10.0       | %                                                                                                    | $          | 42,390,000 |   | 8.0 | % | n/a |   | n/a |   |
| Tier 1 capital (to risk-weighted assets) |       | $          | 48,139,000 |                                         | 8.8        | %                                                                                                    | $          | 21,195,000 |   | 4.0 | % | n/a |   | n/a |   |
| Tier 1 capital (to average assets)       |       | $          | 48,139,000 |                                         | 8.1        | %                                                                                                    | $          | 23,608,000 |   | 4.0 | % | n/a |   | n/a |   |
|                                     |       |       |       |                                         |       |                                                                                                 |       |   |   |   |   |   |   |
| Bank:                                    |       |       |       |                                         |       |                                                                                                 |       |   |   |   |   |   |   |
| Total capital (to risk- weighted assets) |       | $          | 54,822,000 |                                         | 10.4       | %                                                                                                    | $          | 42,348,000 |   | 8.0 | % | $ | 52,935,000 |   | 10.0 | % |
| Tier 1 capital (to risk-weighted assets) |       | $          | 48,187,000 |                                         | 9.1        | %                                                                                                    | $          | 21,174,000 |   | 4.0 | % | $ | 31,761,000 |   | 6.0 | % |
| Tier 1 capital (to average assets)       |       | $          | 48,187,000 |                                         | 8.2        | %                                                                                                    | $          | 23,611,000 |   | 4.0 | % | $ | 29,568,000 |   | 5.0 | % |
|                                     |       |       |       |                                         |       |                                                                                                 |       |   |   |   |   |   |   |
| December 31, 2007                   |       |       |       |                                         |       |                                                                                                 |       |   |   |   |   |   |   |
|                                     |       |       |       |                                         |       |                                                                                                 |       |   |   |   |   |   |   |
| Company:                                 |       |       |       |                                         |       |                                                                                                 |       |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)  |       | $          | 72,206,000 |                                         | 14.1       | %                                                                                                    | $          | 40,849,000 |   | 8.0 | % | n/a |   | n/a |   |
| Tier 1 capital (to risk-weighted assets) |       | $          | 66,974,000 |                                         | 13.1       | %                                                                                                    | $          | 20,425,000 |   | 4.0 | % | n/a |   | n/a |   |
| Tier 1 capital (to average assets)       |       | $          | 66,974,000 |                                         | 11.6       | %                                                                                                    | $          | 23,096,000 |   | 4.0 | % | n/a |   | n/a |   |
|                                     |       |       |       |                                         |       |                                                                                                 |       |   |   |   |   |   |   |
| Bank:                                    |       |       |       |                                         |       |                                                                                                 |       |   |   |   |   |   |   |
| Total capital (to risk- weighted assets) |       | $          | 58,149,000 |                                         | 11.4       | %                                                                                                    | $          | 40,793,000 |   | 8.0 | % | $ | 50,991,000 |   | 10.0 | % |
| Tier 1 capital (to risk-weighted assets) |       | $          | 52,917,000 |                                         | 10.4       | %                                                                                                    | $          | 20,397,000 |   | 4.0 | % | $ | 30,595,000 |   | 6.0 | % |
| Tier 1 capital (to average assets)       |       | $          | 52,917,000 |                                         | 9.3        | %                                                                                                    | $          | 22,756,000 |   | 4.0 | % | $ | 28,445,000 |   | 5.0 | % |

 

89

----

Tableof Contents

 

**12.          OTHER NON-INTERESTINCOME AND EXPENSES**

 

Other non-interest income consisted of thefollowing:

 
| ** **                                 | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                 | ** ** | **2008**                                   | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                       |       |                                       |       |   |   |   |   |
| Alternative investment fees                |       | $                                          | 545,000    |   | $ | 354,000 |   | $ | 350,000 |   |
| Merchant card processing fees              |       | 409,000                                    |       | 403,000 |   | 381,000 |   |
| Earnings from Cash surrender value of bank |       |                                       |       |   |   |   |   |
| owned life insurance                       |       | 564,000                                    |       | 383,000 |   | 331,000 |   |
| Gain on sale of mortgage servicing assets  |       | 22,000                                     |       | 730,000 |   | — |   |
| Payroll Services                           |       | 352,000                                    |       | 207,000 |   | 41,000 |   |
| Insurance sales                            |       | 233,000                                    |       | 207,000 |   | 183,000 |   |
| Sale-lease back proceeds                   |       | 326,000                                    |       | — |   | — |   |
| Other                                      |       | 926,000                                    |       | 868,000 |   | 762,000 |   |
|                                       |       |                                       |       |   |   |   |   |
|                                       |       | $                                          | 3,377,000  |   | $ | 3,152,000 |   | $ | 2,048,000 |   |

 

Other expenses consisted of the following:

 
| ** **                           | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------|------------|--------------------------------------------|------------|
| ** **                           | ** ** | **2008**                                   | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                 |       |                                       |       |   |   |   |   |
| Professional fees                    |       | $                                          | 1,161,000  |   | $ | 1,516,000 |   | $ | 1,269,000 |   |
| Telephone and postage                |       | 659,000                                    |       | 594,000 |   | 630,000 |   |
| Stationery and supplies              |       | 747,000                                    |       | 828,000 |   | 710,000 |   |
| Advertising and promotion            |       | 1,136,000                                  |       | 763,000 |   | 660,000 |   |
| Director fees and retirement accrual |       | 508,000                                    |       | 482,000 |   | 450,000 |   |
| Regulatory assessments               |       | 382,000                                    |       | 140 |   | 116 |   |
| Other                                |       | 2,184,000                                  |       | 2,892,860 |   | 2,535,884 |   |
|                                 |       |                                       |       |   |   |   |   |
|                                 |       | $                                          | 6,777,000  |   | $ | 7,076,000 |   | $ | 6,255,000 |   |

 

90

----

Tableof Contents

 

**13.****                               INCOMETAXES**

 

The provision for income taxes for the yearsended December 31, 2008, 2007 and 2006 consisted of the following:

 
| ** **                 | ** ** | **Federal** | ** ** | **State**  | ** ** | **Total**  | ** ** |
|----------------------------|------------|-------------|------------|------------|------------|------------|------------|
| 2008                       |       |        |       |       |       |       |       |
|                       |       |        |       |       |       |       |       |
| Current                    |       | $           | 4,323,000  |       | $          | 1,257,000  |       | $ | 5,580,000 |   |
| Deferred                   |       | (3,277,000  | )          | (1,171,000 | )          | (4,448,000 | )          |
|                       |       |        |       |       |       |       |       |
| Provision for income taxes |       | $           | 1,046,000  |       | $          | 86,000     |       | $ | 1,132,000 |   |
|                       |       |        |       |       |       |       |       |
| 2007                       |       |        |       |       |       |       |       |
|                       |       |        |       |       |       |       |       |
| Current                    |       | $           | 3,735,000  |       | $          | 1,316,000  |       | $ | 5,051,000 |   |
| Deferred                   |       | (470,000    | )          | (142,000   | )          | (612,000   | )          |
|                       |       |        |       |       |       |       |       |
| Provision for income taxes |       | $           | 3,265,000  |       | $          | 1,174,000  |       | $ | 4,439,000 |   |
|                       |       |        |       |       |       |       |       |
| 2006                       |       |        |       |       |       |       |       |
|                       |       |        |       |       |       |       |       |
| Current                    |       | $           | 4,572,000  |       | $          | 1,580,000  |       | $ | 6,152,000 |   |
| Deferred                   |       | (820,000    | )          | (230,000   | )          | (1,050,000 | )          |
|                       |       |        |       |       |       |       |       |
| Provision for income taxes |       | $           | 3,752,000  |       | $          | 1,350,000  |       | $ | 5,102,000 |   |

 

91

----

Table of Contents

 

Deferred taxassets (liabilities) are comprised of the following at December 31, 2008and 2007:

 
| ** **                                                   | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|--------------------------------------------------------------|------------|------------|------------|------------|------------|
| Deferred tax assets:                                         |       |       |       |       |       |
| Allowance for loan losses                                    |       | $          | 3,686,000  |       | $          | 2,731,000 |   |
| Deferred compensation                                        |       | 3,387,000  |       | 3,090,000  |       |
| Future benefit of state tax deduction                        |       | 447,000    |       | 388,000    |       |
| Premises and equipment                                       |       | 794,000    |       | 635,000    |       |
| Stock based compensation                                     |       | 24,000     |       | 23,000     |       |
| Sale/leaseback                                               |       | 2,414,000  |       | —     |       |
| Impairment of investment security                            |       | 683,000    |       | —     |       |
| Other                                                        |       | 48,000     |       | 12,000     |       |
|                                                         |       |       |       |       |       |
| Total deferred tax assets                                    |       | 11,483,000 |       | 6,879,000  |       |
|                                                         |       |       |       |       |       |
| Deferred tax liabilities:                                    |       |       |       |       |       |
| Future liability of state deferred tax  assets               |       | (895,000   | )          | (486,000   | )          |
| Accrual to cash - deferred loan costs                        |       | (40,000    | )          | (177,000   | )          |
| Prepaid expenses                                             |       | (256,000   | )          | (255,000   | )          |
| Unrealized loss on available-for-sale investment  securities |       | (10,000    | )          | (13,000    | )          |
| Other                                                        |       | —     |       | (117,000   | )          |
|                                                         |       |       |       |       |       |
| Total Deferred tax liabilities                               |       | (1,201,000 | )          | (1,048,000 | )          |
|                                                         |       |       |       |       |       |
| Net deferred tax assets                                      |       | $          | 10,282,000 |       | $          | 5,831,000 |   |

 

The Company believes it is more likely thannot that it will realize the above deferred tax assets in future periods;therefore, no valuation allowance has been provided against its deferred taxassets.

 

The provision for income taxes differs fromamounts computed by applying the statutory Federal income tax rate to operatingincome before income taxes. The items comprising these differences are asfollows:

 
| ** **                                      | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                      | ** ** | **2008**                                   | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                      | ** ** | **Amount**                                 | ** ** | **Rate %** | ** ** | **Amount** | ** ** | **Rate %** | ** ** | **Amount** | ** ** | **Rate %** | ** ** |
| ** **                                      | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Federal income tax expense, at statutory  rate  |       | $                                          | 1,355,000  |   | 35.0 |   | $ | 3,814,000 |   | 35.0 |   | $ | 4,289,000 |   | 35.0 |   |
| State franchise tax, net of Federal tax  effect |       | 56,000                                     |       | 1.4 |   | 763,000 |   | 7.0 |   | 877,000 |   | 7.2 |   |
| Tax-exempt income from life insurance  policies |       | (197,000                                   | )          | (5.1 | ) | (134,000 | ) | (1.2 | ) | (116,000 | ) | (1.0 | ) |
| Other                                           |       | (82,000                                    | )          | (2.1 | ) | (4,000 | ) | (0.0 | ) | 52,000 |   | 0.4 |   |
|                                            |       |                                       |       |   |   |   |   |   |   |   |   |   |   |
|                                            |       | $                                          | 1,132,000  |   | 29.2 |   | $ | 4,439,000 |   | 40.8 |   | $ | 5,102,000 |   | 41.6 |   |

 

The Company and its subsidiary file incometax returns in the U.S. federal and California jurisdictions.  The Company conducts all of its businessactivities in the State of California. There are currently no pending U.S. federal, state, and local income taxor non-U.S. income tax examinations by tax authorities.  With few exceptions, the Company is no longersubject to tax examinations by U.S. Federal taxing authorities for years endedbefore December 31, 2005, and by state and local taxing authorities foryears ended before December 31, 2004. The Company determined the unrecognized tax benefit and changes thereinand the interest and penalties accrued by the Company were not significant at December 31,2008.

 

92

----

Tableof Contents

 

**14.****                               RELATEDPARTY TRANSACTIONS**

 

During the normalcourse of business, the Company enters into transactions with related parties,including Directors and executive officers. These transactions includeborrowings with substantially the same terms, including rates and collateral,as loans to unrelated parties. The following is a summary of the aggregateactivity involving related party borrowers during 2008:

 
| Balance, January 1, 2008                                       |   | $          | 2,408,000 |   |
|---------------------------------------------------------------------|--------|------------|-----------|--------|
|                                                                |   |       |      |
| Disbursements                                                       |   | 11,039,000 |      |
| Amounts repaid                                                      |   | (7,073,000 | )         |
|                                                                |   |       |      |
| Balance, December 31, 2008                                     |   | $          | 6,374,000 |   |
|                                                                |   |       |      |
| Undisbursed commitments to related parties,  December 31, 2008 |   | $          | 1,898,000 |   |

 

The Company engages a related party for certain construction projectsrelated to the Company’s buildings. Total fees paid to this related party for construction activities forthe year ended December 31, 2008, 2007 and 2006 were $36,000, $624,000 and$1,488,000, respectively.

 

**15.****                               EMPLOYEEBENEFIT PLANS**

 

Salary Continuation and Retirement Plans

 

Salary continuation plans are in place for sixteen key executives. Inaddition, a retirement plan is in place for members of the Board of Directors.Under these plans, the directors and executives, or designated beneficiaries,will receive monthly payments for five to twenty years after retirement ordeath. These benefits are substantially equivalent to those available underinsurance policies purchased by the Company on the lives of the directors andexecutives. In addition, the estimated present value of these future benefitsis accrued over the period from the effective dates of the plans until theirexpected retirement dates. The expense recognized under these plans for theyears ended December 31, 2008, 2007 and 2006 totaled $696,000, $944,000,and $1,111,000, respectively.

 

In connection with these plans, the Company purchased single premiumlife insurance policies with cash surrender values totaling $11,199,000 and$10,201,000 at December 31, 2008 and 2007, respectively. Income earned onthese policies, net of expenses, totaled $564,000, $383,000 and $331,000 forthe years ended December 31, 2008, 2007, and 2006, respectively.

 

Savings Plan

 

The Butte Community Bank 401(k) SavingsPlan commenced January 1, 1993 and is available to employees meetingcertain service requirements. Under the plan, employees may defer aselected percentage of their annual compensation. The Bank may make adiscretionary contribution to the plan which would be allocated as follows:

 

·                                          Amatching contribution to be determined by the Board of Directors each plan yearunder which the Bank will match a percentage of each participant’scontribution.

 

·                                          Abasic contribution that would be allocated in the same ratio as eachparticipant’s contribution bears to total compensation.

 

There were no employer contributions for theyears ended December 31, 2008, 2007 or 2006.

 

Employee Stock Ownership Plan

 

Under the Butte Community Bank Employee StockOwnership Plan (“ESOP”), employees who have been credited with at least 1,000hours of service during a twelve month period and who have attained ageeighteen are eligible to participate. The ESOP has funded purchases of the Bank’scommon stock through a line of credit from another financial institution (seeNote 8). The line of credit is repaid from discretionary contributions to theESOP determined by the Bank’s Board of Directors. Annual contributions arelimited on a participant-by-participant basis to the lesser of $30,000 ortwenty-five percent of the participant’s compensation for the year. Employeecontributions are not permitted.

 

93

----

Table of Contents

 

As a leveraged ESOP, interest expense isrecognized on the line of credit in the Company’s consolidated financialstatements. Shares are allocated on the basis of eligible compensation, asdefined in the ESOP plan document, in the year of allocation. Benefitsgenerally become 100% vested after seven years of credited service. Employeeswith at least three, but fewer than seven, years of credited service receive apartial vesting according to a sliding schedule. However, in the event ofnormal retirement, disability, or death, any unvested portion of benefits vestsimmediately.

 

As shares are purchased by the ESOP withproceeds from the line of credit, the Company records the cost of theseunearned ESOP shares as a contra-equity account. These amounts are shown as areduction of shareholders’ equity in the Company’s consolidated balance sheet.As the debt is repaid, the shares are released from unallocated ESOP shares inproportion to the debt service paid during the year and allocated to eligibleemployees. As shares are released from unallocated ESOP shares, the Companyreports compensation expense equal to the current market price of the shares,and the shares are recognized as outstanding for earnings per sharecomputations. Benefits are distributed in the form of qualifying Companysecurities. However, the Company will issue a put option to each participantupon distribution of the securities which, if exercised, requires the Companyto purchase the qualifying securities at fair market value.

 

During 2008 and2006 the ESOP purchased 16,903 and 20,750 shares of the Company’s common stockat a cost of $121,000 and $354,000 using the proceeds from the line of creditto the ESOP.  During 2007, the ESOP didnot purchase any shares of the Company’s stock. Interest expense of $59,000, $94,000 and $88,000 was recognized inconnection with the line of credit during the years ended December 31,2008, 2007 and 2006, respectively.

 

Compensationexpense of $82,000, $172,000 and $609,000 was recognized for the years ended December 31,2008, 2007 and 2006.

 

Allocated and unallocated ESOP shares at December 31,2008, 2007 and 2006 were as follows:

 
| ** **                       | ** ** | **2008** | ** ** | **2007** | ** ** | **2006**  | ** ** |
|----------------------------------|------------|----------|------------|----------|------------|-----------|------------|
|                             |       |     |       |     |       |      |       |
| Allocated shares                 |       | 335,810  |       | 316,524  |       | 289,355   |       |
| Unallocated Shares               |       | 124,207  |       | 126,590  |       | 155,258   |       |
|                             |       |     |       |     |       |      |       |
| Total ESOP Shares                |       | 460,017  |       | 443,114  |       | 444,613   |       |
|                             |       |     |       |     |       |      |       |
| Fair value of unallocated shares |       | $        | 528,000    |     | $          | 1,276,000 |       | $ | 2,344,000 |   |
|                                  |            |          |            |          |            |           |            |  |  |  |

 

94

----

Tableof Contents

 

**16.****                               FAIRVALUE MEASUREMENTS**

 

The carryingamounts and estimated fair values of the Company’s financial instruments are asfollows:

 
| ** **                                                  | ** ** | **December 31, 2008** | ** **  | **December 31, 2007** | ** ** |
|-------------------------------------------------------------|------------|---------------------------------|-------------|---------------------------------|------------|
| ** **                                                  | ** ** | **Carrying  Amount**            | ** **  | **Fair Value**             | ** ** | **Carrying  Amount** | ** ** | **Fair Value** | ** ** |
|                                                        |       |                            |        |                            |       |   |   |   |   |
| Financial assets:                                           |       |                            |        |                            |       |   |   |   |   |
| Cash and due from banks                                     |       | $                               | 21,743,000  |                            | $          | 21,743,000 |   | $ | 31,714,000 |   | $ | 31,714,000 |   |
| Federal Funds sold and other                                |       | 36,605,000                      |        | 36,605,000                      |       | 54,290,000 |   | 54,290,000 |   |
| Interest-bearing deposits in banks                          |       | 2,576,000                       |        | 2,595,000                       |       | 4,250,000 |   | 4,285,000 |   |
| Loans held for sale                                         |       | 320,000                         |        | 320,000                         |       | — |   | — |   |
| Investment securities                                       |       | 7,096,000                       |        | 7,100,000                       |       | 6,264,000 |   | 6,270,000 |   |
| Loans                                                       |       | 486,522,000                     |        | 487,578,000                     |       | 441,350,000 |   | 438,055,000 |   |
| Other investments                                           |       | 1,096,000                       |        | 1,096,000                       |       | 591,000 |   | 591,000 |   |
| Accrued interest receivable                                 |       | 3,838,000                       |        | 3,838,000                       |       | 3,657,000 |   | 3,657,000 |   |
| Cash surrender value of Bank owned life  insurance policies |       | 11,199,000                      |        | 11,199,000                      |       | 10,201,000 |   | 10,201,000 |   |
| Loan servicing assets                                       |       | 2,004,000                       |        | 2,004,000                       |       | 1,104,000 |   | 1,104,000 |   |
|                                                        |       |                            |        |                            |       |   |   |   |   |
| Financial liabilities:                                      |       |                            |        |                            |       |   |   |   |   |
| Deposits                                                    |       | $                               | 526,485,000 |                            | $          | 527,720,000 |   | $ | 500,991,000 |   | $ | 501,437,000 |   |
| Notes payable                                               |       | 5,054,000                       |        | 5,054,000                       |       | 1,093,000 |   | 1,093,000 |   |
| Junior subordinated debentures                              |       | 8,248,000                       |        | 9,205,000                       |       | 16,496,000 |   | 18,230,000 |   |
| Accrued interest payable                                    |       | 645,000                         |        | 645,000                         |       | 985,000 |   | 985,000 |   |

 

Estimated fair values are disclosed forfinancial instruments for which it is practicable to estimate fair value. Theseestimates are made at a specific point in time based on relevant market dataand information about the financial instruments. These estimates do not reflectany premium or discount that could result from offering the Company’s entireholdings of a particular financial instrument for sale at one time, nor do theyattempt to estimate the value of anticipated future business related to theinstruments. In addition, the tax ramifications related to the realization ofunrealized gains and losses can have a significant effect on fair valueestimates and have not been considered in any of these estimates.

 

Because no market exists for a significantportion of the Company’s financial instruments, fair value estimates are basedon judgments regarding current economic conditions, risk characteristics ofvarious financial instruments and other factors. These estimates are subjectivein nature and involve uncertainties and matters of significant judgment andtherefore cannot be determined with precision. Changes in assumptions couldsignificantly affect the fair values presented.

 

The followingmethods and assumptions were used by the Company to estimate the fair value ofits financial instruments at December 31, 2008 and 2007:

 

Cash and cash equivalents:Cash and cash equivalents include cash and due from banks Federal funds soldand certain short-term interest-bearing deposits in banks and the carryingamount is estimated to be fair value.

 

Interest-bearing deposits in banks:The fair values of interest-bearing deposits in banks are estimated bydiscounting their future cash flows using rates at each reporting date forinstruments with similar remaining maturities offered by comparable financialinstitutions.

 

Investment securities:For investment securities, fair values are based on quoted market prices, whereavailable. If quoted market prices are not available, fair values are estimatedusing quoted market prices for similar securities and indications of valueprovided by brokers.

 

Loans: Fair valuesof loans held for sale are estimated using quoted market prices for similarloans or the amount that purchasers have committed to purchase the loans. Forvariable-rate loans that reprice frequently with no significant change incredit risk, fair values are based on carrying values.  The fair values for other loans are estimatedusing discounted cash flow analyses, using interest rates offered at eachreporting date for loans with similar terms to borrowers of comparablecreditworthiness adjusted for the allowance for loan losses. The carryingamount of accrued interest receivable approximates its fair value.

 

Other investments:Other investments include non-marketable equity securities. The carrying valueof these investments approximates their fair value.

 

95

----

Table of Contents

 

Bank owned life insurance policies:The fair values of life insurance policies are based on cash surrender valuesat each reporting date provided by the insurers.

 

Loan servicing assets:The fair value of servicing assets is estimated using projected cash flows,adjusted for the effects of anticipated prepayments, using a market discountrate.

 

Deposits: The fairvalues for demand deposits are, by definition, equal to the amount payable ondemand at each reporting date represented by their carrying amount. Fair valuesfor fixed-rate certificates of deposit are estimated using a discounted cashflow analysis using interest rates offered at each reporting date by the Bankfor certificates with similar remaining maturities. The carrying amount ofaccrued interest payable approximates its fair value.

 

Notes payable: Thenotes payable reprice based upon an independent index. The carrying amount ofthe notes payable approximates its fair value.

 

Junior subordinated debentures:The fair value of the junior subordinated debentures was determined based onthe current market for like-kind instruments of a similar maturity andstructure.

 

Commitments to extend credit and standbyletters of credit: Commitments to extend credit areprimarily for variable rate loans and standby letters of credit. For thesecommitments, there is no difference between the committed amounts and theirfair values. The fair value of the commitments at each reporting date was notsignificant and not included in the accompanying table.

 

 FairValue Measurements Under SFAS No. 157

 

On January 1,2008, the Company adopted Financial Accounting Standards Board (FASB) StatementNo. 157 (SFAS 157),*Fair ValueMeasurements.*  SFAS No. 157defines fair value, establishes a framework for measuring fair value underGAAP, and expands disclosures about fair value measurement.  Upon adoption of SFAS No. 157, there wasno cumulative effect adjustment to beginning retained earnings and no impact onthe financial statements.

 

In October 2008,the FASB issued FSP FAS 157-3, *Determiningthe Fair Value of a Financial Asset When the Market for That Asset Is NotActive*. The FSP was effective immediately and clarifies theapplication of SFAS 157, in a market that is not active and provides an exampleto illustrate key considerations in determining the fair value of a financialasset when the market for that financial asset is not active. The impact ofadoption was not material to the Company’s financial condition or results ofoperations.

 

*Fair ValueHierarchy*

 

The Companygroups its assets and liabilities measured at fair value in three levels, basedon markets in which the assets and liabilities are traded and the reliabilityof the assumptions used to determine fair value. Valuations within these levelsare based upon:

 

Level 1 –Quoted market prices for identical instruments traded in active exchangemarkets.

 

Level 2 –Quoted prices of similar instruments in active markets, quoted prices foridentical or similar instruments in markets that are not active, andmodel-based valuation techniques for which all significant assumptions areobservable or can be corroborated by observable market data.

 

Level 3 –Model-based techniques that use at least one significant assumptions notobservable in the market.  Theseunobservable assumptions reflect the Bank’s estimates of assumptions thatmarket participants would use on pricing the asset or liability. Valuationtechniques included management judgment and estimation which may besignificant.

 

96

----

Tableof Contents

 

Assetsand liabilities measured at fair value on a recurring basis are summarizedbelow:

 
| ** **                                                | ** ** | ** **          | ** ** | **Fair Value Measurements**               | ** ** |
|-----------------------------------------------------------|------------|---------------------|------------|-----------------------------------------------------|------------|
| ** **                                                | ** ** | ** **          | ** ** | **at December 31, 2008, Using** | ** ** |
| ** **                                                | ** ** | ** **          | ** ** | **Quoted Prices in**                      | ** ** | **Other** | ** ** | **Significant** | ** ** |
| ** **                                                | ** ** | ** **          | ** ** | **Active Markets for**                    | ** ** | **Observable** | ** ** | **Unobservable** | ** ** |
| ** **                                                | ** ** | **Fair Value** | ** ** | **Identical Assets**                           | ** ** | **Inputs** | ** ** | **Inputs** | ** ** |
| **Description**                                           | ** ** | **31-Dec-08**       | ** ** | **(Level  1)**                                      | ** ** | **(Level  2)** | ** ** | **(Level  3)** | ** ** |
| Investment securities                                     |       | $                   | 6,462      |                                                | $          | 6,462 |   | $ | — |   | $ | — |   |
| Total assets measured at fair value on a  recurring basis |       | $                   | 6,462      |                                                | $          | 6,462 |   | $ | — |   | $ | — |   |

 

The following methods were used to estimatethe fair value of each class of financial instrument above:

 

**Investment Securities** – Fair values forinvestment securities are based on quoted market prices or quoted market pricesfor similar securities.

 

Assetsmeasured at fair value on a non recurring basis are summarized below:

 
| ** **                                                    | ** ** | **Fair Value Measurements**               | ** ** |
|---------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                    | ** ** | **at December 31, 2008, Using** | ** ** |
| ** **                                                    | ** ** | ** **                                          | ** ** | **Quoted Prices in** | ** ** | **Other** | ** ** | **Significant** | ** ** |
| ** **                                                    | ** ** | ** **                                          | ** ** | **Active Markets for** | ** ** | **Observable** | ** ** | **Unobservable** | ** ** |
| ** **                                                    | ** ** | **Fair Value**                                 | ** ** | **Identical Assets** | ** ** | **Inputs** | ** ** | **Inputs** | ** ** |
| **Description**                                               | ** ** | **31-Dec-08**                                       | ** ** | **(Level 1)** | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| Impaired loans                                                |       | $                                                   | 14,885     |   | $ | — |   | $ | 14,885 |   | $ | — |   |
| Real estate owned                                             |       | $                                                   | 2,068      |   | $ | — |   | $ | 2,068 |   |   |   |
| Total assets measured at fair value on a  non recurring basis |       | $                                                   | 16,953     |   | $ | — |   | $ | 16,953 |   | $ | — |   |

 

Thefollowing methods were used to estimate the fair value of each class offinancial instrument above:

 

**Impaired Loans** -The fair value of impairedloans is based on the fair value of the collateral less estimated costs to sellfor all collateral dependent loans and for other impaired loans is estimatedusing a discounted cash flow model.

 

**Real Estate Owned —**Thefair value of real estate owned is based primarily on the values obtainedthrough property appraisals less estimated costs to sell or similarinformation.

 

97

----

Tableof Contents

 

**17.          PARENTONLY CONDENSED FINANCIAL STATEMENTS**

 

**CONDENSEDBALANCE SHEET**

 

**December 31,2008 and 2007**

 
| ** **                                            | ** ** | **2008**   | ** ** | **2007**   | ** ** |
|-------------------------------------------------------|------------|------------|------------|------------|------------|
|                                                  |       |       |       |       |       |
| **ASSETS**                                            |
|                                                  |       |       |       |       |       |
| Cash and cash equivalents                             |       | $          | 205,000    |       | $          | 12,326,000 |   |
| Investment in bank subsidiary                         |       | 49,297,000 |       | 52,917,000 |       |
| Investment in non-bank subsidiary                     |       | 659,000    |       | 660,000    |       |
| Other assets                                          |       | 3,428,000  |       | 3,596,000  |       |
|                                                  |       |       |       |       |       |
| Total assets                                          |       | $          | 53,589,000 |       | $          | 69,499,000 |   |
|                                                  |       |       |       |       |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**        |
|                                                  |       |       |       |       |       |
| Liabilities:                                          |       |       |       |       |       |
| Notes Payable                                         |       | $          | 5,054,000  |       | $          | 1,093,000 |   |
| Junior subordinated debentures                        |       | 8,248,000  |       | 16,496,000 |       |
| Other liabilities                                     |       | 148,000    |       | 936,000    |       |
|                                                  |       |       |       |       |       |
| Total liabilities                                     |       | 13,450,000 |       | 18,525,000 |       |
|                                                  |       |       |       |       |       |
| Shareholders’ equity                             |       |       |       |       |       |
| Common stock                                          |       | 10,147,000 |       | 10,910,000 |       |
| Unallocated ESOP shares                               |       | (1,438,000 | )          | (1,407,000 | )          |
| Retained earnings                                     |       | 31,416,000 |       | 41,454,000 |       |
| Accumulated other comprehensive income, net  of taxes |       | 14,000     |       | 17,000     |       |
|                                                  |       |       |       |       |       |
| Total shareholders’ equity                       |       | 40,139,000 |       | 50,974,000 |       |
|                                                  |       |       |       |       |       |
| Total liabilities and shareholders’ equity       |       | $          | 53,589,000 |       | $          | 69,499,000 |   |

 

98

----

Tableof Contents

 

**17.          PARENTONLY CONDENSED FINANCIAL STATEMENTS**

 

**CONDENSEDSTATEMENT OF INCOME**

 

**For the YearsEnded December 31, 2008, 2007 and 2006**

 
| ** **                                                    | ** ** | **2008**   | ** ** | **2007**  | ** ** | **2006**  | ** ** |
|---------------------------------------------------------------|------------|------------|------------|-----------|------------|-----------|------------|
|                                                          |       |       |       |      |       |      |       |
| Income:                                                       |       |       |       |      |       |      |       |
| Dividends declared by bank subsidiary                         |       | $          | 11,238,000 |      | $          | 4,251,000 |       | $ | 3,039,000 |   |
|                                                          |       |       |       |      |       |      |       |
| Expenses:                                                     |       |       |       |      |       |      |       |
| Professional fees                                             |       | 518,000    |       | 367,000   |       | 347,000   |       |
| Interest expense                                              |       | 770,000    |       | 1,118,000 |       | 821,000   |       |
| Other expenses                                                |       | 282,000    |       | 380,000   |       | 790,000   |       |
|                                                          |       |       |       |      |       |      |       |
| Total expenses                                                |       | 1,570,000  |       | 1,865,000 |       | 1,958,000 |       |
|                                                          |       |       |       |      |       |      |       |
| Income before equity in undistributed  income of subsidiaries |       | 9,668,000  |       | 2,386,000 |       | 1,081,000 |       |
|                                                          |       |       |       |      |       |      |       |
| Equity in undistributed income of  subsidiaries               |       | (7,578,000 | )          | 3,335,000 |       | 5,416,000 |       |
|                                                          |       |       |       |      |       |      |       |
| Income before income tax benefit                              |       | 2,090,000  |       | 5,721,000 |       | 6,497,000 |       |
|                                                          |       |       |       |      |       |      |       |
| Income tax benefit                                            |       | 649,000    |       | 738,000   |       | 654,000   |       |
|                                                          |       |       |       |      |       |      |       |
| Net Income                                                    |       | $          | 2,739,000  |      | $          | 6,459,000 |       | $ | 7,151,000 |   |

 

99

----

Tableof Contents

 

**17.          PARENTONLY CONDENSED FINANCIAL STATEMENTS**

 

**CONDENSEDSTATEMENT OF CASH FLOWS**

 

**For the Years Ended December 31, 2008,2007 and 2006**

 
| ** **                                                                         | ** ** | **2008**    | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|------------------------------------------------------------------------------------|------------|-------------|------------|------------|------------|------------|------------|
| ** **                                                                         |       |        |       |       |       |       |       |
| Cash flows from operating activities:                                              |       |        |       |       |       |       |       |
| Net income                                                                         |       | $           | 2,739,000  |       | $          | 6,459,000  |       | $ | 7,151,000 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |        |       |       |       |       |       |
| Undistributed net income of subsidiary                                             |       | 7,578,000   |       | (3,335,000 | )          | (5,416,000 | )          |
| Stock-based compensation                                                           |       | 80,000      |       | 139,000    |       | 175,000    |       |
| Decrease (increase) in other assets                                                |       | 129,000     |       | (678,000   | )          | (54,000    | )          |
| (Decrease) increase in other liabilities                                           |       | (58,000     | )          | 146,000    |       | 25,000     |       |
| Net cash provided by operating activities                                          |       | 10,468,000  |       | 2,731,000  |       | 1,881,000  |       |
|                                                                               |       |        |       |       |       |       |       |
| Cash flows from investing activities:                                              |       |        |       |       |       |       |       |
| Investment in Butte Community Bank                                                 |       | (3,960,000  | )          | —     |       | —     |       |
| Net cash used in investing activities                                              |       | (3,960,000  | )          | —     |       | —     |       |
|                                                                               |       |        |       |       |       |       |       |
| Cash flows from financing activities:                                              |       |        |       |       |       |       |       |
| Proceeds from notes payable                                                        |       | 4,120,000   |       | —     |       | 354,000    |       |
| Repayment of notes payable                                                         |       | (159,000    | )          | (124,000   | )          | (119,000   | )          |
| Proceeds from issuance of junior  subordinated debentures                          |       | (8,248,000  | )          | 8,248,000  |       | —     |       |
| Purchase of unallocated ESOP shares                                                |       | (121,000    | )          | —     |       | (354,000   | )          |
| Proceeds from exercise of stock options,  including tax benefit                    |       | 654,000     |       | 1,104,000  |       | 1,000,000  |       |
| Payment of cash dividends                                                          |       | (1,757,000  | )          | (2,408,000 | )          | (1,637,000 | )          |
| Repurchase of common stock                                                         |       | (13,118,000 | )          | (210,000   | )          | (2,498,000 | )          |
| Net cash used by financing activities                                              |       | (18,629,000 | )          | 6,610,000  |       | (3,254,000 | )          |
|                                                                               |       |        |       |       |       |       |       |
| Increase (decrease) in cash and cash  equivalents                                  |       | (12,121,000 | )          | 9,341,000  |       | (1,373,000 | )          |
|                                                                               |       |        |       |       |       |       |       |
| Cash and cash equivalents at beginning of  year                                    |       | 12,326,000  |       | 2,985,000  |       | 4,358,000  |       |
|                                                                               |       |        |       |       |       |       |       |
| Cash and cash equivalents at end of year                                           |       | $           | 205,000    |       | $          | 12,326,000 |       | $ | 2,985,000 |   |

 

**18.          SUBSEQUENT EVENTS**

 

Merchant Credit Card Portfolio

 

The Company has entered into a contract with a third party vendor topurchase the merchant credit card processing portfolio.  It is believed this transaction will takeplace in March 2009.

 

100

----