UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549





FORM
10-Q




x
              QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934


For the
quarterly period ended June 30, 2009.





or





 ̈
              TRANSITION REPORT PURSUANT TO
      SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934


For the
transition period from _______ to _______.





Commission
File Number:  000-25020





HERITAGE
OAKS BANCORP


(Exact
name of registrant as specified in its charter)





California
              77-0388249(State
      or other jurisdiction of
              (I.R.S.
      Employerincorporation
      or organization)
              Identification
      No.)545
      12th Street,Paso
      Robles, California
              93446(Address
      of principal offices)
              (Zip
      Code)





(805)
369-5200


(Registrant's
telephone number, including area code)





Not
Applicable


(Former
name, former address and former fiscal year, if changed since last
report)





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





YES x     NO
 ̈





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Website, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding
12 months (or for such shorter period that the registrant was required to submit
and post such files).





YES  ̈     NO
 ̈





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or smaller reporting
company.  See definitions of “large accelerated filer,” “accelerated
filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act (check
one.)





Large
accelerated filer  ̈     Accelerated
filer x     Non-accelerated
filer  ̈    Smaller
reporting company  ̈





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





YES  ̈      NO
x





Indicate
the number of shares outstanding of each of the issuer's classes of common
stock, as of the latest practicable date:  As of August 5, 2009 there
were 7,761,554 shares outstanding of the Registrant’s common stock.












PagePart
      I.  Financial Information
                  
                  3Item
      1.  Consolidated Financial Statements (un-audited, except for
      Balance Sheet as of 12/31/2008)
                  
                  3Consolidated
      Balance Sheets
                  
                  4Consolidated
      Income Statements
                  
                  5Consolidated
      Statements of Stockholders' Equity
                  
                  6Consolidated
      Statements of Comprehensive Income
                  
                  7Consolidated
      Statements of Cash Flows
                  
                  8Notes
      to Consolidated Financial Statements
                  
                  9Note
      1.  Consolidated Financial Statements
                  
                  9Note
      2.  Investment Securities
                  
                  9Note
      3.  Loans and the Allowance for Loan Losses
                  
                  11Note
      4.  Earnings Per Share
                  
                  12Note
      5.  Recent Accounting Pronouncements
                  
                  13Note
      6.  Share-Based Compensation
                  
                  16Note
      7.  Fair Value Disclosures
                  
                  19Note
      8.  Fair Value of Financial Instruments
                  
                  21Note
      9.  Preferred Stock
                  
                  23Note
      10.  Subsequent Events
                  
                  24Note
      11.  Reclassifications
                  
                  24Forward
      Looking Statements
                  
                  25Item
      2.  Management's Discussion and Analysis of Financial Condition
      and Results of Operations
                  
                  26The
      Company
                  
                  26Where
      You Can Find More Information
                  
                  26Executive
      Summary
                  
                  27Recent
      Developments
                  
                  29Dividends
      and Stock Repurchases
                  
                  29Selected
      Financial Data
                  
                  30Local
      Economy
                  
                  30Critical
      Accounting Policies
                  
                  31Results
      of Operations
                  
                  33Net
      Interest Income and Margin
                  
                  33Non-Interest
      Income
                  
                  38Non-Interest
      Expenses
                  
                  40Provision
      for Income Taxes
                  
                  41Provision
      for Loan Losses
                  
                  41Financial
      Condition Analysis
                  
                  43Loans
                  
                  43Non-Performing
      Assets
                  
                  48Total
      Cash and Cash Equivalents
                  
                  51Investment
      Securities and Other Earning Assets
                  
                  52Deposits
      and Borrowed Funds
                  
                  53Capital
                  
                  55Liquidity
                  
                  57Inflation
                  
                  58Off-Balance
      Sheet Arrangements
                  
                  58Item
      3.  Quantative and Qualitative Disclosure About Market
      Risk
                  
                  59Item
      4.  Controls and Procedures
                  
                  60Part
      II.  Other Information
                  
                  61Item
      1.  Legal Proceedings
                  
                  61Item
      1A.  Risk Factors
                  
                  61Item
      2.  Unregistered Sales of Equity Securities and Use of
      Proceeds
                  
                  61Item
      3.  Defaults upon Senior Securities
                  
                  61Item
      4.  Submission of Matters to a Vote of Security
      Holders
                  
                  62Item
      5.  Other Information1
                  
                  62Item
      6.  Exhibits
                  
                  62Signatures
                  
                  63




- 2
-




Part
I.  Financial Information





Item
1. Consolidated Financial Statements





The
financial statements and the notes thereto begin on next page.




- 3
-




Heritage
Oaks Bancorp


and
Subsidiaries


Consolidated
Balance Sheets





(audited)June
      30,
                                        
                                        
                                        December
      31,(dollars
      in thousands except per share data)
                                        
                                        2009
                                        
                                        
                                        2008AssetsCash
      and due from banks
                                        
                                        $
                                        15,667
                                        
                                        
                                        $
                                        17,921Federal
      funds sold
                                        
                                        
                                        32,675
                                        
                                        
                                        
                                        6,650Total
      cash and cash equivalents
                                        
                                        
                                        48,342
                                        
                                        
                                        
                                        24,571Interest
      bearing deposits with other banks
                                        
                                        
                                        119
                                        
                                        
                                        
                                        119Securities
      available for sale
                                        
                                        
                                        75,726
                                        
                                        
                                        
                                        50,762Federal
      Home Loan Bank stock, at cost
                                        
                                        
                                        5,828
                                        
                                        
                                        
                                        5,123Loans
      held for sale
                                        
                                        
                                        11,692
                                        
                                        
                                        
                                        7,939Loans,
      net of deferred fees of $1,555 and $1,701 and allowance for loan loss of
      $11,106 and $10,412 at June 30, 2009 and December 31, 2008,
      respectively
                                        
                                        
                                        685,193
                                        
                                        
                                        
                                        668,034Property,
      premises and equipment, net
                                        
                                        
                                        6,848
                                        
                                        
                                        
                                        6,827Deferred
      tax assets
                                        
                                        
                                        8,673
                                        
                                        
                                        
                                        7,708Bank
      owned life insurance
                                        
                                        
                                        10,949
                                        
                                        
                                        
                                        10,737Goodwill
                                        
                                        
                                        11,049
                                        
                                        
                                        
                                        11,049Core
      deposit intangible
                                        
                                        
                                        3,166
                                        
                                        
                                        
                                        3,691Other
      real estate owned
                                        
                                        
                                        6,669
                                        
                                        
                                        
                                        1,337Other
      assets
                                        
                                        
                                        7,101
                                        
                                        
                                        
                                        7,691Total
      assets
                                        
                                        $
                                        881,355
                                        
                                        
                                        $
                                        805,588LiabilitiesDepositsDemand,
      non-interest bearing
                                        
                                        $
                                        178,600
                                        
                                        
                                        $
                                        147,044Savings,
      NOW, and money market deposits
                                        
                                        
                                        290,178
                                        
                                        
                                        
                                        296,488Time
      deposits of $100 or more
                                        
                                        
                                        125,325
                                        
                                        
                                        
                                        75,111Time
      deposits under $100
                                        
                                        
                                        109,886
                                        
                                        
                                        
                                        84,878Total
      deposits
                                        
                                        
                                        703,989
                                        
                                        
                                        
                                        603,521Short
      term FHLB borrowing
                                        
                                        
                                        55,000
                                        
                                        
                                        
                                        99,000Long
      term FHLB borrowing
                                        
                                        
                                        10,000
                                        
                                        
                                        
                                        10,000Securities
      sold under agreement to repurchase
                                        
                                        
                                        -
                                        
                                        
                                        
                                        2,796Junior
      subordinated debentures
                                        
                                        
                                        13,403
                                        
                                        
                                        
                                        13,403Other
      liabilities
                                        
                                        
                                        7,649
                                        
                                        
                                        
                                        6,836Total
      liabilities
                                        
                                        
                                        790,041
                                        
                                        
                                        
                                        735,556Commitments
      and contingencies
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -Stockholders'
      EquitySenior
      preferred stock, no par value; $1,000 per share stated value 5,000,000
      shares authorized, 21,000 and 0 issued and outstanding as of June 30, 2009
      and December 31, 2008, respectively.
                                        
                                        
                                        19,253
                                        
                                        
                                        
                                        -Common
      stock, no par value; 20,000,000 shares authorized, issued and outstanding
      7,761,554 and 7,753,078 as of June 30, 2009 and December 31, 2008,
      respectively.
                                        
                                        
                                        48,695
                                        
                                        
                                        
                                        48,649Additional
      paid in capital
                                        
                                        
                                        3,087
                                        
                                        
                                        
                                        1,055Retained
      earnings
                                        
                                        
                                        22,768
                                        
                                        
                                        
                                        21,420Accumulated
      other comprehensive loss, net of tax benefit of $1,740 and $763 as of
      June 30, 2009 and December 31, 2008, respectively.
                                        
                                        
                                        (2,489
                                        )
                                        
                                        
                                        (1,092
                                        )Total
      stockholders' equity
                                        
                                        
                                        91,314
                                        
                                        
                                        
                                        70,032Total
      liabilities and stockholders' equity
                                        
                                        $
                                        881,355
                                        
                                        
                                        $
                                        805,588





See notes
to condensed consolidated financial statements.




- 4
-




Heritage
Oaks Bancorp


and
Subsidiaries


Consolidated
Statements of Income





For
      the three months
                                                    
                                                    
                                                    For
      the six monthsended
      June 30,
                                                    
                                                    
                                                    ended
      June 30,(dollars
      in thousands except per share data)
                                                    
                                                    2009
                                                    
                                                    
                                                    2008
                                                    
                                                    
                                                    2009
                                                    
                                                    
                                                    2008Interest
      IncomeInterest
      and fees on loans
                                                    
                                                    $
                                                    11,416
                                                    
                                                    
                                                    $
                                                    11,732
                                                    
                                                    
                                                    $
                                                    22,563
                                                    
                                                    
                                                    $
                                                    23,823Interest
      on investment securitiesMortgage
      backed securities
                                                    
                                                    
                                                    625
                                                    
                                                    
                                                    
                                                    546
                                                    
                                                    
                                                    
                                                    1,173
                                                    
                                                    
                                                    
                                                    966Obligations
      of state and political subdivisions
                                                    
                                                    
                                                    208
                                                    
                                                    
                                                    
                                                    185
                                                    
                                                    
                                                    
                                                    394
                                                    
                                                    
                                                    
                                                    369Interest
      on time deposits with other banks
                                                    
                                                    
                                                    1
                                                    
                                                    
                                                    
                                                    3
                                                    
                                                    
                                                    
                                                    2
                                                    
                                                    
                                                    
                                                    6Interest
      on federal funds sold
                                                    
                                                    
                                                    10
                                                    
                                                    
                                                    
                                                    45
                                                    
                                                    
                                                    
                                                    17
                                                    
                                                    
                                                    
                                                    112Interest
      on other securities
                                                    
                                                    
                                                    9
                                                    
                                                    
                                                    
                                                    63
                                                    
                                                    
                                                    
                                                    16
                                                    
                                                    
                                                    
                                                    115Total
      interest income
                                                    
                                                    
                                                    12,269
                                                    
                                                    
                                                    
                                                    12,574
                                                    
                                                    
                                                    
                                                    24,165
                                                    
                                                    
                                                    
                                                    25,391Interest
      ExpenseInterest
      on savings, NOW and money market deposits
                                                    
                                                    
                                                    839
                                                    
                                                    
                                                    
                                                    1,020
                                                    
                                                    
                                                    
                                                    1,656
                                                    
                                                    
                                                    
                                                    2,526Interest
      on time deposits in denominations of $100 or more
                                                    
                                                    
                                                    631
                                                    
                                                    
                                                    
                                                    525
                                                    
                                                    
                                                    
                                                    1,175
                                                    
                                                    
                                                    
                                                    1,205Interest
      on time deposits under $100
                                                    
                                                    
                                                    664
                                                    
                                                    
                                                    
                                                    674
                                                    
                                                    
                                                    
                                                    1,228
                                                    
                                                    
                                                    
                                                    1,574Other
      borrowings
                                                    
                                                    
                                                    293
                                                    
                                                    
                                                    
                                                    766
                                                    
                                                    
                                                    
                                                    697
                                                    
                                                    
                                                    
                                                    1,377Total
      interest expense
                                                    
                                                    
                                                    2,427
                                                    
                                                    
                                                    
                                                    2,985
                                                    
                                                    
                                                    
                                                    4,756
                                                    
                                                    
                                                    
                                                    6,682Net
      interest income before provision for possible loan losses
                                                    
                                                    
                                                    9,842
                                                    
                                                    
                                                    
                                                    9,589
                                                    
                                                    
                                                    
                                                    19,409
                                                    
                                                    
                                                    
                                                    18,709Provision
      for possible loan losses
                                                    
                                                    
                                                    2,700
                                                    
                                                    
                                                    
                                                    2,775
                                                    
                                                    
                                                    
                                                    4,810
                                                    
                                                    
                                                    
                                                    3,015Net
      interest income after provision for possible loan losses
                                                    
                                                    
                                                    7,142
                                                    
                                                    
                                                    
                                                    6,814
                                                    
                                                    
                                                    
                                                    14,599
                                                    
                                                    
                                                    
                                                    15,694Non
      Interest IncomeFees
      and service charges
                                                    
                                                    
                                                    752
                                                    
                                                    
                                                    
                                                    837
                                                    
                                                    
                                                    
                                                    1,464
                                                    
                                                    
                                                    
                                                    1,609Gain
      on sale of investment securities
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    37
                                                    
                                                    
                                                    
                                                    122
                                                    
                                                    
                                                    
                                                    37Loss
      on sale of OREO
                                                    
                                                    
                                                    (104
                                                    )
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    (131
                                                    )
                                                    
                                                    
                                                    -Other
                                                    
                                                    
                                                    852
                                                    
                                                    
                                                    
                                                    882
                                                    
                                                    
                                                    
                                                    1,705
                                                    
                                                    
                                                    
                                                    1,549Total
      non-interest income
                                                    
                                                    
                                                    1,500
                                                    
                                                    
                                                    
                                                    1,756
                                                    
                                                    
                                                    
                                                    3,160
                                                    
                                                    
                                                    
                                                    3,195Non
      Interest ExpensesSalaries
      and employee benefits
                                                    
                                                    
                                                    3,745
                                                    
                                                    
                                                    
                                                    4,021
                                                    
                                                    
                                                    
                                                    7,548
                                                    
                                                    
                                                    
                                                    8,246Equipment
                                                    
                                                    
                                                    376
                                                    
                                                    
                                                    
                                                    351
                                                    
                                                    
                                                    
                                                    701
                                                    
                                                    
                                                    
                                                    717Occupancy
                                                    
                                                    
                                                    826
                                                    
                                                    
                                                    
                                                    778
                                                    
                                                    
                                                    
                                                    1,678
                                                    
                                                    
                                                    
                                                    1,551Other
                                                    
                                                    
                                                    3,067
                                                    
                                                    
                                                    
                                                    2,348
                                                    
                                                    
                                                    
                                                    5,512
                                                    
                                                    
                                                    
                                                    4,604Total
      non-interest expenses
                                                    
                                                    
                                                    8,014
                                                    
                                                    
                                                    
                                                    7,498
                                                    
                                                    
                                                    
                                                    15,439
                                                    
                                                    
                                                    
                                                    15,118Income
      before provision for income taxes
                                                    
                                                    
                                                    628
                                                    
                                                    
                                                    
                                                    1,072
                                                    
                                                    
                                                    
                                                    2,320
                                                    
                                                    
                                                    
                                                    3,771Provision
      for income taxes
                                                    
                                                    
                                                    121
                                                    
                                                    
                                                    
                                                    381
                                                    
                                                    
                                                    
                                                    711
                                                    
                                                    
                                                    
                                                    1,405Net
      income
                                                    
                                                    
                                                    507
                                                    
                                                    
                                                    
                                                    691
                                                    
                                                    
                                                    
                                                    1,609
                                                    
                                                    
                                                    
                                                    2,366Dividends
      and accretion on preferred stock
                                                    
                                                    
                                                    250
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    261
                                                    
                                                    
                                                    
                                                    -Net
      income available to common shareholders
                                                    
                                                    $
                                                    257
                                                    
                                                    
                                                    $
                                                    691
                                                    
                                                    
                                                    $
                                                    1,348
                                                    
                                                    
                                                    $
                                                    2,366Earnings
      Per Common ShareBasic
                                                    
                                                    $
                                                    0.03
                                                    
                                                    
                                                    $
                                                    0.09
                                                    
                                                    
                                                    $
                                                    0.17
                                                    
                                                    
                                                    $
                                                    0.31Diluted
                                                    
                                                    $
                                                    0.03
                                                    
                                                    
                                                    $
                                                    0.09
                                                    
                                                    
                                                    $
                                                    0.17
                                                    
                                                    
                                                    $
                                                    0.30





See notes
to condensed consolidated financial statements.




- 5
-




Heritage
Oaks Bancorp


and
Subsidiaries


Consolidated
Statements of Stockholders' Equity





AccumulatedPreferred
      Stock
                                                  
                                                  
                                                  Common
      Stock
                                                  
                                                  
                                                  Additional
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  Other
                                                  
                                                  
                                                  TotalNumber
      of
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  Number
      of
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  Paid-In
                                                  
                                                  
                                                  Comprehensive
                                                  
                                                  
                                                  Retained
                                                  
                                                  
                                                  Comprehensive
                                                  
                                                  
                                                  Stockholders'(dollars
      in thousands)
                                                  
                                                  Shares
                                                  
                                                  
                                                  Amount
                                                  
                                                  
                                                  Shares
                                                  
                                                  
                                                  Amount
                                                  
                                                  
                                                  Capital
                                                  
                                                  
                                                  Income
                                                  
                                                  
                                                  Earnings
                                                  
                                                  
                                                  Income
                                                  
                                                  
                                                  EquityBalance,
      December 31, 2008
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  $
                                                  -
                                                  
                                                  
                                                  
                                                  7,753,078
                                                  
                                                  
                                                  $
                                                  48,649
                                                  
                                                  
                                                  $
                                                  1,055
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  $
                                                  21,420
                                                  
                                                  
                                                  $
                                                  (1,092
                                                  )
                                                  
                                                  $
                                                  70,032Issuance
      of preferred stock and common stock warrant
                                                  
                                                  
                                                  21,000
                                                  
                                                  
                                                  
                                                  19,152
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  1,848
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  21,000Amortization
      of discount on preferred stock
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  101
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  (101
                                                  )
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  -Dividends
      paid on preferred stock
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  (160
                                                  )
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  (160
                                                  )Exercise
      of stock options
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  -(including
      $9 excess tax benefit
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  -from
      exercise of stock options)
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  10,050
                                                  
                                                  
                                                  
                                                  46
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  46Share-based
      compensation expense
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  184
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  184Retirement
      of restricted share awards
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  (1,575
                                                  )Comprehensive
      income:Net
      income
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  $
                                                  1,609
                                                  
                                                  
                                                  
                                                  1,609
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  1,609Unrealized
      security holding gains(net of $1,027 tax
      benefit)
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  (1,469
                                                  )
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  (1,469
                                                  )
                                                  
                                                  
                                                  (1,469
                                                  )Realized
      gains on sale of securities(net of $50
      tax)
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  72
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  72
                                                  
                                                  
                                                  
                                                  72Total
      comprehensive income
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  $
                                                  212Balance,
      June 30, 2009
                                                  
                                                  
                                                  21,000
                                                  
                                                  
                                                  $
                                                  19,253
                                                  
                                                  
                                                  
                                                  7,761,553
                                                  
                                                  
                                                  $
                                                  48,695
                                                  
                                                  
                                                  $
                                                  3,087
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  $
                                                  22,768
                                                  
                                                  
                                                  $
                                                  (2,489
                                                  )
                                                  
                                                  $
                                                  91,314Balance,
      December 31, 2007
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  $
                                                  -
                                                  
                                                  
                                                  
                                                  7,317,932
                                                  
                                                  
                                                  $
                                                  43,996
                                                  
                                                  
                                                  $
                                                  672
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  $
                                                  24,598
                                                  
                                                  
                                                  $
                                                  184
                                                  
                                                  
                                                  $
                                                  69,450Exercise of stock
      options
                                                    (including $88 excess
      tax benefit from
      exercise of stock options)
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  31,228
                                                  
                                                  
                                                  
                                                  228
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  2285%
      Stock Dividend distributed May 16, 2008
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  366,344
                                                  
                                                  
                                                  
                                                  4,232
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  (4,232
                                                  )
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  -Cash
      paid in lieu of fractional shares
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  (5
                                                  )
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  (5
                                                  )Cash
      dividends - $0.08 per share
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  (587
                                                  )
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  (587
                                                  )Share-based
      compensation expense
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  167
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  167Issuance
      of restricted stock awards
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  1,000
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  -Retirement
      of restricted share awards
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  (6,575
                                                  )
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  -Comprehensive
      income:Net
      income
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  $
                                                  2,366
                                                  
                                                  
                                                  
                                                  2,366
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  2,366Unrealized
      security holding gains(net of $537 tax
      benefit)
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  (769
                                                  )
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  (769
                                                  )
                                                  
                                                  
                                                  (769
                                                  )Realized
      gains on sale of securities(net of $15
      tax)
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  22
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  22
                                                  
                                                  
                                                  
                                                  22Total
      comprehensive income
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  $
                                                  1,619Balance,
      June 30, 2008
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  $
                                                  -
                                                  
                                                  
                                                  
                                                  7,709,929
                                                  
                                                  
                                                  $
                                                  48,456
                                                  
                                                  
                                                  $
                                                  839
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  $
                                                  22,140
                                                  
                                                  
                                                  $
                                                  (563
                                                  )
                                                  
                                                  $
                                                  70,872





See notes
to condensed consolidated financial statements.




- 6
-




Heritage
Oaks Bancorp


and
Subsidiaries


Consolidated
Statements of Comprehensive Income





For
      the three months
                          
                          
                          For
      the six monthsended
      June 30,
                          
                          
                          ended
      June 30,(dollars
      in thousands)
                          
                          2009
                          
                          
                          2008
                          
                          
                          2009
                          
                          
                          2008Net
      income
                          
                          $
                          507
                          
                          
                          $
                          691
                          
                          
                          $
                          1,609
                          
                          
                          $
                          2,366Other
      comprehensive loss before taxesUnrealized
      losses on securities available for sale
                          
                          
                          (1,370
                          )
                          
                          
                          (1,611
                          )
                          
                          
                          (2,496
                          )
                          
                          
                          (1,307
                          )Realized
      gains on sale of available for sale securities
                          
                          
                          -
                          
                          
                          
                          37
                          
                          
                          
                          122
                          
                          
                          
                          37Total
      other comprehensive loss before taxes
                          
                          
                          (1,370
                          )
                          
                          
                          (1,574
                          )
                          
                          
                          (2,374
                          )
                          
                          
                          (1,270
                          )Unrealized
      income tax benefit related to items in comprehensive loss
                          
                          
                          564
                          
                          
                          
                          663
                          
                          
                          
                          1,027
                          
                          
                          
                          538Income
      tax related to the sale of available for sale securities
                          
                          
                          -
                          
                          
                          
                          (15
                          )
                          
                          
                          (50
                          )
                          
                          
                          (15
                          )Total
      other comprehensive loss, net of taxes
                          
                          
                          (806
                          )
                          
                          
                          (926
                          )
                          
                          
                          (1,397
                          )
                          
                          
                          (747
                          )Total
      comprehensive (loss) / income
                          
                          $
                          (299
                          )
                          
                          $
                          (235
                          )
                          
                          $
                          212
                          
                          
                          $
                          1,619





See notes
to condensed consolidated financial statements.




- 7
-




Heritage
Oaks Bancorp


and
Subsidiaries


Consolidated
Statements of Cash Flows





For
      the six month periodsended
      June 30,(dollars
      in thousands)
                                      
                                      2009
                                      
                                      
                                      2008Cash
      flows from operating activities:Net
      income
                                      
                                      $
                                      1,609
                                      
                                      
                                      $
                                      2,366Adjustments
      to reconcile net income to net cash provided by operating
      activities:Depreciation
      and amortization
                                      
                                      
                                      547
                                      
                                      
                                      
                                      537Provision
      for possible loan losses
                                      
                                      
                                      4,810
                                      
                                      
                                      
                                      3,015Amortization
      of premiums / discounts on investment securities, net
                                      
                                      
                                      29
                                      
                                      
                                      
                                      (66
                                      )Amortization
      of intangible assets
                                      
                                      
                                      525
                                      
                                      
                                      
                                      430Share-based
      compensation expense
                                      
                                      
                                      184
                                      
                                      
                                      
                                      167Federal
      Home Loan Bank dividends received
                                      
                                      
                                      -
                                      
                                      
                                      
                                      (84
                                      )Gain
      on sale of available for sale securities
                                      
                                      
                                      (122
                                      )
                                      
                                      
                                      (37
                                      )Increase
      in loans held for sale
                                      
                                      
                                      (3,753
                                      )
                                      
                                      
                                      (344
                                      )Net
      increase in bank owned life insurance
                                      
                                      
                                      (212
                                      )
                                      
                                      
                                      (204
                                      )Decrease
      in deferred tax asset
                                      
                                      
                                      12
                                      
                                      
                                      
                                      14Loss
      on sale and write-downs on other real estate owned
                                      
                                      
                                      204
                                      
                                      
                                      
                                      -Increase
      in other assets
                                      
                                      
                                      (7,799
                                      )
                                      
                                      
                                      (483
                                      )Increase
      / (decrease) in other liabilities
                                      
                                      
                                      822
                                      
                                      
                                      
                                      (795
                                      )Excess
      tax benefit related to share-based compensation expense
                                      
                                      
                                      (9
                                      )
                                      
                                      
                                      (88
                                      )NET
      CASH (USED) / PROVIDED IN OPERATING ACTIVITIES
                                      
                                      
                                      (3,153
                                      )
                                      
                                      
                                      4,428Cash
      flows from investing activities:Purchase
      of securities, available for sale
                                      
                                      
                                      (38,553
                                      )
                                      
                                      
                                      (18,417
                                      )Sale
      of available for sale securities
                                      
                                      
                                      4,762
                                      
                                      
                                      
                                      1,537Maturities
      and calls of available for sale securities
                                      
                                      
                                      1,136
                                      
                                      
                                      
                                      1,012Maturities
      of time deposits with other banks
                                      
                                      
                                      -
                                      
                                      
                                      
                                      199Proceeds
      from principal reductions and maturities of available for sale
      securities
                                      
                                      
                                      5,410
                                      
                                      
                                      
                                      5,193Purchase
      of Federal Home Loan Bank stock
                                      
                                      
                                      (705
                                      )
                                      
                                      
                                      (2,272
                                      )Increase
      in loans, net
                                      
                                      
                                      (21,991
                                      )
                                      
                                      
                                      (47,673
                                      )Allowance
      for loan and lease loss recoveries
                                      
                                      
                                      22
                                      
                                      
                                      
                                      72Purchase
      of property, premises and equipment, net
                                      
                                      
                                      (578
                                      )
                                      
                                      
                                      (720
                                      )Purchase
      of bank owned life insurance
                                      
                                      
                                      -
                                      
                                      
                                      
                                      (400
                                      )Proceeds
      from sale of other real estate owned
                                      
                                      
                                      2,863
                                      
                                      
                                      
                                      -NET
      CASH (USED) IN INVESTING ACTIVITIES
                                      
                                      
                                      (47,634
                                      )
                                      
                                      
                                      (61,469
                                      )Cash
      flows from financing activities:Increase
      / (decrease) in deposits, net
                                      
                                      
                                      100,468
                                      
                                      
                                      
                                      (10,290
                                      )Proceeds
      from Federal Home Loan Bank borrowing
                                      
                                      
                                      75,000
                                      
                                      
                                      
                                      240,000Repayments
      of Federal Home Loan Bank borrowing
                                      
                                      
                                      (119,000
                                      )
                                      
                                      
                                      (176,500
                                      )(Decrease)
      / increase in repurchase agreements
                                      
                                      
                                      (2,796
                                      )
                                      
                                      
                                      782Excess
      tax benefit related to share-based compensation expense
                                      
                                      
                                      9
                                      
                                      
                                      
                                      88Proceeds
      from exercise of stock options
                                      
                                      
                                      37
                                      
                                      
                                      
                                      140Cash
      dividends paid
                                      
                                      
                                      (160
                                      )
                                      
                                      
                                      (587
                                      )Cash
      paid in lieu of fractional shares
                                      
                                      
                                      -
                                      
                                      
                                      
                                      (5
                                      )Proceeds
      from issuance of preferred stock and common stock warrants,
      net
                                      
                                      
                                      21,000
                                      
                                      
                                      
                                      -NET
      CASH PROVIDED BY FINANCING ACTIVITIES
                                      
                                      
                                      74,558
                                      
                                      
                                      
                                      53,628Net
      increase / (decrease) in cash and cash equivalents
                                      
                                      
                                      23,771
                                      
                                      
                                      
                                      (3,413
                                      )Cash
      and cash equivalents, beginning of period
                                      
                                      
                                      24,571
                                      
                                      
                                      
                                      46,419Cash
      and cash equivalents, end of period
                                      
                                      $
                                      48,342
                                      
                                      
                                      $
                                      43,006Supplemental
      Cash Flow Disclosures:Cash
      Flow informationInterest
      paid
                                      
                                      $
                                      4,836
                                      
                                      
                                      $
                                      6,819Income
      taxes paid
                                      
                                      $
                                      220
                                      
                                      
                                      $
                                      1,405Non-Cash
      Flow InformationChange
      in other valuation allowance for investment securities
                                      
                                      $
                                      (2,374
                                      )
                                      
                                      $
                                      (1,270
                                      )Loans
      transferred to OREO or foreclosed collateral
                                      
                                      $
                                      8,403
                                      
                                      
                                      $
                                      197See
      notes to condensed consolidated financial statements.




- 8
-




Notes to
Consolidated Financial Statements




Note
1.  Consolidated Financial Statements





The
accompanying un-audited condensed consolidated financial statements of Heritage
Oaks Bancorp and subsidiaries (the “Company”) have been prepared in accordance
with the instructions to Form 10-Q and Article 10 of Regulation S-X.
Accordingly, certain information and notes required by accounting principles
generally accepted in the United States of America for annual financial
statements are not included herein. In the opinion of Management, all
adjustments (which consist solely of normal recurring accruals) considered
necessary for a fair presentation of results for the interim periods presented
have been included. These interim condensed consolidated financial statements
should be read in conjunction with the financial statements and related notes
contained in the Company’s 2008 Annual Report filed on Form 10-K.





The
condensed consolidated financial statements include the accounts of the Company
and its wholly-owned financial subsidiary, Heritage Oaks Bank (“the
Bank”).  All significant inter-company balances and transactions have
been eliminated. Heritage Oaks Capital Trusts II and III are unconsolidated
subsidiaries formed solely for the purpose of issuing trust preferred
securities. Operating results for the three and six months ended June 30, 2009
are not necessarily indicative of the results that may be expected for the year
ending December 31, 2009. Certain amounts in the consolidated financial
statements for the year ended December 31, 2008 and for the three and six months
ended June 30, 2008 may have been reclassified to conform to the presentation of
the consolidated financial statements in 2009.





The
preparation of consolidated financial statements in conformity with the
accounting principles generally accepted in the United States of America
requires Management to make estimates and assumptions.  These
estimates and assumptions affect the reported amounts of assets and liabilities
at the date of the consolidated financial statements and the reported amounts of
revenues and expenses during the reporting period.  Actual results
could differ from these estimates.





Management
evaluated subsequent events through July 28, 2009, the date the financial
statements were available to be issued.  Events or transactions
occurring after June 30, 2009, but prior to July 28, 2009 that
provided additional evidence about conditions that existed at June 30,
2009, have been recognized in the financial statements for the quarter ended
June 30, 2009.  Events or transactions that provided evidence
about conditions that did not exist at June 30, 2009, but arose before the
financial statements were available to be issued have not been recognized in the
financial statements for the period ended June 30, 2009.




Note
2.  Investment Securities





In
accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115
“Accounting for Certain
Investments in Debt and Equity Securities,” which addresses the
accounting for investments in equity securities that have readily determinable
fair values and for investments in all debt securities, securities are
classified in three categories and accounted for as follows: debt and
mortgage-backed securities that the Company has the positive intent and ability
to hold to maturity are classified as held-to-maturity and are measured at
amortized cost; debt and equity securities bought and held principally for the
purpose of selling in the near term are classified as trading securities and are
measured at fair value, with the unrealized gains and losses included in
earnings; debt and equity securities not classified as either held-to-maturity
or trading securities are deemed as available-for-sale and are measured at fair
value, with the unrealized gains and losses, net of applicable taxes, reported
in a separate component of stockholders’ equity. Any gains and losses on sales
of investments are computed on a specific identification
basis.  Premiums and discounts are amortized or accreted using the
interest method over the lives of the related securities.




- 9
-









The
following table sets forth the amortized cost and fair values of investment
securities available for sale at June 30, 2009 and December 31,
2008:





(dollars
      in thousands)
                                      
                                      
                                      
                                      
                                      Gross
                                      
                                      
                                      GrossAmortized
                                      
                                      
                                      Unrealized
                                      
                                      
                                      Unrealized
                                      
                                      
                                      FairAs
      of June 30, 2009
                                      
                                      Cost
                                      
                                      
                                      Gains
                                      
                                      
                                      Losses
                                      
                                      
                                      ValueObligations
      of U.S. government agencies and corporations
                                      
                                      $
                                      145
                                      
                                      
                                      $
                                      -
                                      
                                      
                                      $
                                      (2
                                      )
                                      
                                      $
                                      143Mortgage
      backed securities
                                      
                                      
                                      58,629
                                      
                                      
                                      
                                      256
                                      
                                      
                                      
                                      (4,598
                                      )
                                      
                                      
                                      54,287Obligations
      of state and political subdivisions
                                      
                                      
                                      21,072
                                      
                                      
                                      
                                      361
                                      
                                      
                                      
                                      (246
                                      )
                                      
                                      
                                      21,187Other
      securities
                                      
                                      
                                      109
                                      
                                      
                                      
                                      -
                                      
                                      
                                      
                                      -
                                      
                                      
                                      
                                      109Total
                                      
                                      $
                                      79,955
                                      
                                      
                                      $
                                      617
                                      
                                      
                                      $
                                      (4,846
                                      )
                                      
                                      $
                                      75,726As
      of December 31, 2008Obligations
      of U.S. government agencies and corporations
                                      
                                      $
                                      149
                                      
                                      
                                      $
                                      -
                                      
                                      
                                      $
                                      (1
                                      )
                                      
                                      $
                                      148Mortgage-backed
      securities
                                      
                                      
                                      35,339
                                      
                                      
                                      
                                      166
                                      
                                      
                                      
                                      (2,102
                                      )
                                      
                                      
                                      33,403Obligations
      of state and political subdivisions
                                      
                                      
                                      17,020
                                      
                                      
                                      
                                      373
                                      
                                      
                                      
                                      (291
                                      )
                                      
                                      
                                      17,102Other
      securities
                                      
                                      
                                      109
                                      
                                      
                                      
                                      -
                                      
                                      
                                      
                                      -
                                      
                                      
                                      
                                      109Total
                                      
                                      $
                                      52,617
                                      
                                      
                                      $
                                      539
                                      
                                      
                                      $
                                      (2,394
                                      )
                                      
                                      $
                                      50,762




During
the first quarter of 2009, the Company sold five securities in the aggregate
amount of $4.8 million.  In connection with the sale, the Company
recognized a pre tax gain of $122 thousand.  During the second quarter
of 2008, the Bank sold approximately $5.2 million in securities and recognized a
pre tax gain of $37 thousand.  No securities were sold during the
three months ended June 30, 2009.





Management
periodically evaluates investments in the portfolio for other than temporary
impairment and more specifically when conditions warrant such an
evaluation.  When evaluating whether impairment is other than
temporary, Management considers, among other things, the following: (1) the
length of time the security has been in an unrealized loss position, (2) the
extent to which the security’s fair value is less than its cost, (3) the
financial condition of the issuer, (4) any adverse changes in ratings issued by
various rating agencies, (5) the intent and ability of the Bank to hold such
securities for a period of time sufficient to allow for any anticipated recovery
in fair value and (6) in the case of mortgage related securities, credit
enhancements, loan-to-values, credit scores, delinquency and default rates, cash
flows and the extent to which those cash flows are within Management’s initial
expectations based on pre-purchase analyses.





As of
June 30, 2009, Management does not believe unrealized losses in the investment
portfolio are other than temporary.




- 10
-









Note
3.  Loans and the Allowance for Loan Losses





The
following table provides a summary of outstanding loan balances as of June 30,
2009 compared to December 31, 2008:





June
      30,
                                
                                
                                December
      31,(dollars
      in thousands)
                                
                                2009
                                
                                
                                2008Real
      Estate SecuredMulti-family
      residential
                                
                                $
                                17,414
                                
                                
                                $
                                16,206Residential
      1 to 4 family
                                
                                
                                23,626
                                
                                
                                
                                23,910Home
      equity lines of credit
                                
                                
                                29,049
                                
                                
                                
                                26,409Commercial
                                
                                
                                302,735
                                
                                
                                
                                285,631Farmland
                                
                                
                                9,639
                                
                                
                                
                                10,723CommercialCommercial
      and industrial
                                
                                
                                171,208
                                
                                
                                
                                157,674Agriculture
                                
                                
                                14,231
                                
                                
                                
                                13,744Other
                                
                                
                                491
                                
                                
                                
                                620ConstructionSingle
      family residential
                                
                                
                                14,710
                                
                                
                                
                                11,414Single
      family residential - Spec.
                                
                                
                                10,338
                                
                                
                                
                                15,395Tract
                                
                                
                                3,202
                                
                                
                                
                                2,431Multi-family
                                
                                
                                5,648
                                
                                
                                
                                5,808Hospitality
                                
                                
                                12,388
                                
                                
                                
                                18,630Commercial
                                
                                
                                17,215
                                
                                
                                
                                21,484Land
                                
                                
                                57,149
                                
                                
                                
                                61,681Installment
      loans to individuals
                                
                                
                                8,428
                                
                                
                                
                                7,851All
      other loans (including overdrafts)
                                
                                
                                383
                                
                                
                                
                                536Total
      loans, gross
                                
                                
                                697,854
                                
                                
                                
                                680,147Deferred
      loan fees
                                
                                
                                1,555
                                
                                
                                
                                1,701Reserve
      for possible loan losses
                                
                                
                                11,106
                                
                                
                                
                                10,412Total
      loans, net
                                
                                $
                                685,193
                                
                                
                                $
                                668,034Loans
      held for sale
                                
                                
                                11,692
                                
                                
                                
                                7,939




Concentration
of Credit Risk





At June
30, 2009, approximately $503.1 million or 72.1% of the Bank’s loan portfolio was
collateralized by various forms of real estate, this represents an increase of
approximately $3.4 million when compared to the $499.7 million or 73.5% reported
at December 31, 2008.  Such loans are generally made to borrowers
located in San Luis Obispo and Santa Barbara Counties. The Bank attempts to
reduce its concentration of credit risk by making loans which are diversified by
industry and project type. While Management believes that the collateral
presently securing this portfolio is adequate, there can be no assurances
that further significant deterioration in the California real estate market
would not expose the Bank to significantly greater credit risk.  At
June 30, 2009, the Bank was contingently liable for letters of credit
accommodations made to its customers totaling approximately $18.1 million and
un-disbursed loan commitments in the approximate amount of $201.2 million. The
Bank makes commitments to extend credit in the normal course of business to meet
the financing needs of its customers. Commitments to extend credit are
agreements to lend to a customer as long as there is no violation of any
condition established in the contract. Commitments generally have fixed
expiration dates or other termination clauses and may require payment of a fee.
Since many of the commitments are expected to expire without being drawn upon,
the total outstanding commitment amount does not necessarily represent future
cash requirements. Standby letters of credit written are conditional commitments
issued by the Bank to guarantee the performance of a customer to a third party.
The credit risk involved in issuing letters of credit is essentially the same as
those involved in extending loan facilities to customers. The Bank anticipates
no losses as a result of such transactions. For more detailed information on
Concentration of Credit Risk, please refer to “Loans” of “Financial Condition”
under “Management’s Discussion and Analysis of Results and Operations” contained
within this document.




- 11
-









Allowance
for Loan Losses





An
allowance for loan losses has been established by Management to provide for
those loans that may not be repaid in their entirety for a variety of reasons.
The allowance is maintained at a level considered by Management to be adequate
to provide for probable incurred losses.  The allowance is increased
by provisions charged to earnings and is reduced by charge-offs, net of
recoveries. The provision for loan losses is based upon past loan loss
experience and Management’s evaluation of the loan portfolio under current
economic conditions.  Loans are charged to the allowance for loan
losses when, and to the extent, they are deemed by Management to be
un-collectible.





The
following table provides a summary for the activity in the allowance for loan
losses during the periods indicated:





For
      the three months ended
                        
                        
                        For
      the six months ended
                        
                        
                        For
      the year ended(dollars
      in thousands)
                        
                        June
      30, 2009
                        
                        
                        June
      30, 2008
                        
                        
                        June
      30, 2009
                        
                        
                        June
      30, 2008
                        
                        
                        December
      31, 2008Balance
      at beginning of period
                        
                        $
                        10,429
                        
                        
                        $
                        6,305
                        
                        
                        $
                        10,412
                        
                        
                        $
                        6,143
                        
                        
                        $
                        6,143Provision
      expense
                        
                        
                        2,700
                        
                        
                        
                        2,775
                        
                        
                        
                        4,810
                        
                        
                        
                        3,015
                        
                        
                        
                        12,215Loans
      charged-off:Commercial
      real estate
                        
                        
                        -
                        
                        
                        
                        305
                        
                        
                        
                        -
                        
                        
                        
                        305
                        
                        
                        
                        3401-4
      family residential
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        555Commercial
      and industrial
                        
                        
                        942
                        
                        
                        
                        492
                        
                        
                        
                        1,225
                        
                        
                        
                        568
                        
                        
                        
                        3,854Construction
                        
                        
                        415
                        
                        
                        
                        206
                        
                        
                        
                        1,821
                        
                        
                        
                        206
                        
                        
                        
                        1,837Land
                        
                        
                        681
                        
                        
                        
                        -
                        
                        
                        
                        991
                        
                        
                        
                        -
                        
                        
                        
                        1,434Other
                        
                        
                        4
                        
                        
                        
                        21
                        
                        
                        
                        101
                        
                        
                        
                        23
                        
                        
                        
                        56Total
      charge-offs
                        
                        
                        2,042
                        
                        
                        
                        1,024
                        
                        
                        
                        4,138
                        
                        
                        
                        1,102
                        
                        
                        
                        8,076Recoveries
      of loans previously charged off
                        
                        
                        19
                        
                        
                        
                        72
                        
                        
                        
                        22
                        
                        
                        
                        72
                        
                        
                        
                        130Balance
      at end of period
                        
                        $
                        11,106
                        
                        
                        $
                        8,128
                        
                        
                        $
                        11,106
                        
                        
                        $
                        8,128
                        
                        
                        $
                        10,412




During
the three and six months ended June 30, 2009, the Company made provisions to the
allowance for loan losses in the amounts of $2.7 million and $4.8 million,
respectively.  This when compared to the $2.8 million and $3.0 million
reported for the same periods ended a year earlier, represents a decline of
approximately $0.1 million for the quarter and an increase of approximately $1.8
million on a year to date basis.  Elevated provision expenses are
reflective of, among other things, additional loan balances charged-off during
the first six months of 2009, continued weakness in local, state and national
economic conditions and the number and dollar volume of loans placed on
non-accruing status when compared to the same period ended in 2008.




Note
4.  Earnings Per Share





Basic
earnings per common share are computed by dividing net income available to
common shareholders by the weighted-average number of common shares
outstanding.  Diluted earnings per common share are computed by
dividing net income available to common shareholders by the weighted-average
number of common shares outstanding adjusted to include the effect of
potentially dilutive common shares.  Potentially dilutive common
shares are calculated using the Treasury Stock Method and include incremental
shares issuable upon exercise of outstanding stock options and other share-based
compensation awards, exclusive of any award that may have an anti-dilutive
affect on earnings per common share.  As disclosed in Note 9 of these
consolidated financial statements, the Company issued a warrant to the U.S.
Treasury to purchase 611,650 shares of its common stock.  The warrant
was included in the Company’s calculation of diluted earnings per common share
for the three months ended June 30, 2009, but excluded from the calculation on a
year to date basis, since it was anti-dilutive for that
period.




- 12
-










The
following table sets forth the number of shares used in the calculation of both
basic and diluted earnings per share for the three months ended June 30, 2009
and 2008:





For
      the three months ending,June
      30, 2009
                                          
                                          
                                          June
      30, 2008Net
                                          
                                          
                                          
                                          
                                          
                                          Net(dollar
      amounts in thousands except per share data)
                                          
                                          Income
                                          
                                          
                                          Shares
                                          
                                          
                                          Income
                                          
                                          
                                          SharesNet
      income
                                          
                                          $
                                          507
                                          
                                          
                                          
                                          
                                          
                                          $
                                          691Dividends
      and accretion on preferred stock
                                          
                                          
                                          (250
                                          )
                                          
                                          
                                          
                                          
                                          
                                          -Net
      income available to common shareholders
                                          
                                          $
                                          257
                                          
                                          
                                          
                                          
                                          
                                          $
                                          691Weighted
      average shares outstanding
                                          
                                          
                                          
                                          
                                          
                                          
                                          7,696,027
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          7,705,174Basic
      earnings per common share
                                          
                                          $
                                          0.03
                                          
                                          
                                          
                                          
                                          
                                          
                                          $
                                          0.09Dilutive
      effect of share-based compensation awards
                                          
                                          
                                          
                                          
                                          
                                          
                                          94,681
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          125,216Dilutive
      effect of common stock warrant
                                          
                                          
                                          
                                          
                                          
                                          
                                          76,254
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          -Weighted
      average diluted shares outstanding
                                          
                                          
                                          
                                          
                                          
                                          
                                          7,866,962
                                          
                                          
                                          
                                          
                                          
                                          
                                          
                                          7,830,390Diluted
      earnings per common share
                                          
                                          $
                                          0.03
                                          
                                          
                                          
                                          
                                          
                                          
                                          $
                                          0.09





The
following table sets forth the number of shares used in the calculation of both
basic and diluted earnings per share for the six months ended June 30, 2009 and
2008:





For
      the six months ending,June
      30, 2009
                                        
                                        
                                        June
      30, 2008Net
                                        
                                        
                                        
                                        
                                        
                                        Net(dollar
      amounts in thousands except per share data)
                                        
                                        Income
                                        
                                        
                                        Shares
                                        
                                        
                                        Income
                                        
                                        
                                        SharesNet
      income
                                        
                                        $
                                        1,609
                                        
                                        
                                        
                                        
                                        
                                        $
                                        2,366Dividends
      and accretion on preferred stock
                                        
                                        
                                        (261
                                        )
                                        
                                        
                                        
                                        
                                        
                                        -Net
      income available to common shareholders
                                        
                                        $
                                        1,348
                                        
                                        
                                        
                                        
                                        
                                        $
                                        2,366Weighted
      average shares outstanding
                                        
                                        
                                        
                                        
                                        
                                        
                                        7,692,765
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        7,699,860Basic
      earnings per common share
                                        
                                        $
                                        0.17
                                        
                                        
                                        
                                        
                                        
                                        
                                        $
                                        0.31Dilutive
      effect of share-based compensation awards
                                        
                                        
                                        
                                        
                                        
                                        
                                        85,606
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        141,284Dilutive
      effect of common stock warrant
                                        
                                        
                                        
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        -Weighted
      average diluted shares outstanding
                                        
                                        
                                        
                                        
                                        
                                        
                                        7,778,371
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        7,841,144Diluted
      earnings per common share
                                        
                                        $
                                        0.17
                                        
                                        
                                        
                                        
                                        
                                        
                                        $
                                        0.30





On April
24, 2008, the Company’s Board of Directors declared a 5% stock dividend which
was paid on May 16, 2008.  As a result of this dividend, the Company
issued 366,294 shares of its common stock to holders of record on May 2,
2008.  The basic and diluted shares presented in the tables above as
well as shares for all prior periods have been adjusted to fully reflect the May
2008 stock dividend.




Note
5.  Recent Accounting Pronouncements





In June
2009, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 168,
“The FASB Accounting Standards
CodificationTM and the Hierarchy of Generally Accepted Accounting Principles, a
replacement of FASB Statement No. 162.”  The FASB Accounting Standards
CodificationTM
(“Codification”) will become the source of authoritative U.S. generally accepted
accounting principles (“GAAP”) recognized by the FASB to be applied by
nongovernmental entities. Rules and interpretive releases of the Securities and
Exchange Commission (SEC) under authority of federal securities laws are also
sources of authoritative GAAP for SEC registrants.  On the effective
date of this Statement, all interim and annual reporting periods ending after
September 15, 2009, the Codification will supersede all then-existing non-SEC
accounting and reporting standards. All other non-grandfathered non-SEC
accounting literature not included in the Codification will become
non-authoritative.  The Company does not currently believe the
adoption of this statement will have a material impact on its financial
statements.




- 13
-









In June
2009, the FASB issued SFAS No. 167, “Amendments to FASB Interpretation
No. 46(R).”  SFAS No. 167 seeks to improve financial reporting
by companies involved with variable interest entities. SFAS No. 167 addresses
concerns about the application of certain key provisions of Interpretation No.
46(R), including those in which the accounting and disclosures under the
Interpretation do not always provide timely and useful information about a
company’s involvement in a variable interest entity.  SFAS No. 167
requires a company to perform analyses to determine if its variable interest(s)
give it a controlling financial interest in a variable interest
entity.  These analyses identify the primary beneficiary of the a
variable interest entity as the company that has both of the following
characteristics: (a) the power to direct the activities of a variable interest
entity that most significantly impact the company’s economic performance; and
(b) the obligation to absorb losses of the entity that could potentially be
significant to the variable interest entity or the right to receive benefits
from the entity that could potentially be significant to the variable interest
entity.  This statement is effective for all annual and interim
reporting periods beginning after November 15, 2009 with earlier application
prohibited.  The Company has not yet determined the impact that SFAS
No. 167 will have on its financial statements.





In June
2009, the FASB issued SFAS No. 166, “Accounting for Transfers of
Financial Assets, an Amendment of FASB Statement 140.”  SFAS
No. 166 seeks to improve the relevance, representational faithfulness and
comparability of the information that a reporting entity provides in its
financial statements about a transfer of financial assets; the effects of a
transfer on its financial position, financial performance, and cash flows; and a
transferor’s continuing involvement, if any, in transferred financial
assets.  The Company is required to adopt SFAS No. 166 for all interim
and annual reporting periods beginning after November 15, 2009.  The
Company does not currently expect the adoption of this standard to have a
material impact on its financial statements.





In May
2009, the FASB issued SFAS No. 165, “Subsequent
Events.”  SFAS No. 165 sets forth principles and requirements
for disclosing and recognizing subsequent events in the financial
statements.  SFAS No. 165 also outlines circumstances under which an
entity shall recognize those events or transactions occurring after the balance
sheet date.  The Company is required to adopt SFAS No. 165 for all
interim and annual reporting periods after June 15, 2009,
prospectively.  The Company’s adoption of this pronouncement did not
have a material impact on its financial statements.





In April
2009, the FASB issued the following new accounting standards:





The FASB
issued FASB Staff Position (“FSP”) FAS 157-4, “Determining Whether a Market Is Not
Active and a Transaction Is Not Distressed,” FSP FAS 157-4 provides
guidelines for making fair value measurements more consistent with the
principles presented in SFAS 157. FSP FAS 157-4 provides additional
authoritative guidance in determining whether a market is active or inactive,
and whether a transaction is distressed, is applicable to all assets and
liabilities (i.e. financial and nonfinancial) and will require enhanced
disclosures.





The FASB
issued FSP FAS 115-2, FAS 124-2, and EITF 99-20-2, “Recognition and Presentation of
Other-Than-Temporary Impairments,”  The FSP amends FASB
Statements No. 115, Accounting
for Certain Investments in Debt and Equity Securities, No. 124, Accounting for Certain Investments Held by
Not-for-Profit Organizations, and EITF Issue No. 99-20, “Recognition of Interest Income and
Impairment on Purchased Beneficial Interests and Beneficial Interests That
Continue to Be Held by a Transferor in Securitized Financial Assets,” to
make the other-than-temporary impairment guidance more operational and to
improve the presentation of other-than-temporary impairments in the financial
statements.  This statement applies to other-than-temporary
impairments of debt and equity securities and requires a company to assert that
(a) it does not have the intent to sell the security in question and (b) it is
more likely than not that it will not have to sell the security in question
before recovery of its cost basis to avoid an impairment being considered
other-than-temporary.  This FSP also changes the amount of impairment
losses recognized in earnings.  Under this FSP impairments are
separated into two components: (i) the amount of impairments related to credit
losses and (ii) and the amount related to other factors.  The amount
of impairment related to credit losses is reflected as a charge to earnings,
while the amount deemed to be related to other factors is reflected as an
adjustment to shareholders’ equity through other comprehensive
income.





The FASB
issued FSP FAS 107-1 and APB 28-1, “Interim Disclosures about Fair
Value of Financial Instrument.” FSP FAS 107-1 and APB 28-1, amends FASB
Statement No. 107, “Disclosures about Fair Value of
Financial Instruments,” to require disclosures about fair value of
financial instruments in interim as well as in annual financial statements. This
FSP also amends APB Opinion No. 28, “Interim Financial
Reporting,” to require those disclosures in all interim financial
statements.





The
standards summarized in the preceding paragraphs are effective for periods
ending after June 15, 2009.  The adoption of these standards has not
had a material impact in the Company’s financial statements.




- 14
-









On April
1, 2009, the FASB issued FSP FAS 141(R)-1, “Accounting for Assets Acquired and
Liabilities Assumed in a Business Combination That Arise from
Contingencies.”FSP 141(R)-1 provides additional guidance
regarding the recognition, measurement and disclosure of assets and liabilities
arising from contingencies in a business combination.  FSP 141(R)-1 is
effective for assets or liabilities arising from contingencies in business
combinations for which the acquisition date is on or after the beginning of the
first annual reporting period beginning on or after December 15,
2008.  The impact of adopting FSP 141(R)-1 will depend on the timing
of future acquisitions, as well as the nature and existence of contingencies
associated with such acquisitions.





In
December 2008, the FASB issued FSP FAS 132(R)-1, “Employers’ Disclosures about
Postretirement Benefit Plan Assets.”  FSP FAS 132(R)-1 amends FASB
Statement No. 132(R) to provide guidance on an employer’s disclosures about plan
assets of a defined benefit pension or other postretirement plan.  FSP
FAS 132(R)-1 seeks to provide users of financial statements with an
understanding of: how investment allocation decisions are made, the major
categories of plan assets, the inputs and valuations techniques used to measure
the fair value of those assets, the effect of fair value measurements using
unobservable inputs on changes in plan assets during a reporting period, and
significant concentrations of risk within plan assets.  The Company is
required to adopt FSP FAS 132(R)-1 no later than January 1, 2010.  The
Company does not believe the adoption of this FSP will have a material impact on
its financial statements.





On
October 10, 2008, the FASB issued FSP FAS 157-3, “Determining the Fair Value of a
Financial Asset When the Market for That Asset Is Not Active.” The FSP
clarifies the application of SFAS No. 157, “Fair Value Measurements”, in
a market that is not active and provides an example to illustrate key
considerations in determining the fair value of a financial asset when the
market for that financial asset is not active. The FSP is effective immediately,
and includes prior periods for which financial statements have not been issued,
and therefore the Company is subject to the provisions under the FSP effective
September 30, 2008. The implementation of FSP FAS 157-3 did not affect the
Company's fair value measurements as of June 30, 2009.





In June
2008, the FASB issued Staff Position No. EITF 03-6-1, Determining Whether Instruments
Granted in Share-Based Payment Transactions Are Participating Securities
("FSP EITF 03-6-1"). The FSP addresses whether instruments granted in
share-based payment transactions are participating securities prior to vesting
and, therefore, need to be included in the earnings allocation in computing EPS
under the two-class method. The FSP affects entities that accrue cash dividends
on share-based payment awards during the awards' service period when the
dividends do not need to be returned if the employees forfeit the
awards.  FSP EITF 03-6-1 is effective for fiscal years beginning
after December 15, 2008.  The adoption of FSP EITF 03-6-1 did not
have material impact on the Company’s financial position, results of operations
and cash flows.





In May
2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted
Accounting Principles.”  SFAS No. 162
identifies the sources of accounting principles and the framework for selecting
the principles to be used in the preparation of the financial statements of
nongovernmental entities that are presented in conformity with generally
accepted accounting principles (“GAAP”) in the Unites States. The FASB issued
SFAS No. 162, because the current GAAP hierarchy, as set forth in the American
Institute of Certified Public Accountants (“AICPA”) Statement on Auditing
Standards No. 69, “The Meaning
of Present Fairly in Conformity With Generally Accepted Accounting
Principles,” is directed to the auditor and not the entity, it is
complex, and it ranks FASB Statements of Financial Accounting Concepts below
industry practices that are widely recognized as generally accepted but that are
not subject to due process.  This statement is effective 60 days
following the SEC’s approval of the Public Company Accounting Oversight Board
(“PCAOB”) amendments to AU Section 411, “The Meaning of Present Fairly in
Conformity With Generally Accepted Accounting Principles.”  The
adoption of SFAS No. 162 did not have a material impact on the Company’s
financial position, results of operations or cash flows.





In May
2008, the FASB issued SFAS No. 163, “Accounting for Financial Guarantee
Insurance Contracts, an interpretation of FASB Statement No.
60.”   SFAS No. 163 seeks to bring consistency in the
recognition and measurement of claim liabilities.  This statement also
clarifies how SFAS No. 60 applies to financial guarantee contracts, including
the recognition and measurement to be used to account for premium revenue and
claim liabilities, increasing the comparability in financial reporting of
financial guarantee contracts by insurance enterprises.  The Company
must adopt SFAS No. 163 no later than January 1, 2009.  The Company’s
adoption of SFAS No. 163 did not have a material impact on its financial
position, results of operations or cash flows.





In March
2008, the FASB issued SFAS No. 161,“Disclosures about Derivative
Instruments and Hedging Activities – an amendment of FASB Statement
No. 133,”which amends and expands the disclosure requirements of
SFAS No. 133 with the intent to provide users of financial statements with an
enhanced understanding of: how and why an entity uses derivative instruments;
how derivative instruments and related hedged items are accounted for under SFAS
No. 133 and its related interpretations; and how derivative instruments and
related hedged items affect an entity’s financial position, results of
operations, and cash flows.  To meet those objectives, this Statement
requires qualitative disclosures about objectives and strategies for using
derivatives, quantitative disclosures about fair value amounts of and gains and
losses on derivative instruments, and disclosures about credit-risk-related
contingent features in derivative agreements. This Statement is effective for
fiscal years and interim periods beginning after November 15, 2008 with
earlier adoption encouraged. Disclosures will not be required retrospectively to
prior reporting periods. The Company has elected to adopt SFAS No. 161 effective
January 1, 2009. The Company’s adoption of this standard did not have a
material impact on its financial position, results of operations or cash
flows.




- 15
-









In
February 2008, the FASB issued FSP FAS 157-1, “Application of FASB Statement No.
157 and Other Accounting Pronouncements That Address Fair Value Measurements for
Purposes of Lease Classification or Measurement Under Statement 13,” and
FSP FAS 157-2, “Effective Date
of FASB Statement No. 157.” FSP FAS 157-1 removes leasing from the scope
of SFAS No. 157, “Fair Value
Measurements.” FSP FAS 157-2 delays the effective date of SFAS No. 157
from 2008 to 2009 for all non-financial assets and non-financial liabilities,
except those that are recognized or disclosed at fair value in the financial
statements on a recurring basis (at least annually). The Company was required to
adopt FSP FAS 157-1 no later than January 1, 2009.  The adoption of
this pronouncement did not have a material impact on the Company’s financial
position, results of operations and cash flows.





In
December 2007, the FASB issued SFAS No. 141 (revised), “Business Combinations.” SFAS
No. 141(R) changes the accounting for business combinations including the
measurement of acquirer shares issued in consideration for a business
combination, the recognition of contingent consideration, the accounting for
pre-acquisition gain and loss contingencies, the recognition of capitalized
in-process research and development, the accounting for acquisition-related
restructuring cost accruals, the treatment of acquisition related transaction
costs and the recognition of changes in the acquirer’s income tax valuation
allowance. The Company is required to adopt SFAS No. 141(R) no later than
January 1, 2009.  The adoption of SFAS No. 141(R) did not have a
material impact on the Company’s financial position, results of operations or
cash flows.





In
December 2007, the FASB issued SFAS No. 160, “Non-controlling Interests in
Consolidated Financial Statements, an amendment of ARB No. 51.”  SFAS No. 160
changes the accounting for non-controlling (minority) interests in consolidated
financial statements including the requirements to classify non-controlling
interests as a component of consolidated stockholders’ equity, and the
elimination of “minority interest” accounting in results of operations with
earnings attributable to non-controlling interests reported as part of
consolidated earnings.  Additionally, SFAS No. 160 revises the
accounting for both increases and decreases in a parent’s controlling ownership
interest. The Company must adopt SFAS No. 160 no later than January 1,
2009.  The adoption of SFAS No. 160 did not have a material impact on
the Company’s financial position, results of operations or cash
flows.




Note
6.  Share-Based Compensation





As of
June 30, 2009, the Company had two share-based employee compensation plans,
which are more fully described in Note 14 of the Consolidated Financial
Statements in the Company's Annual Report filed on Form 10-K for the year ended
December 31, 2008. These plans include the “1997 Stock Option Plan” and the
“2005 Equity Based Compensation Plan.”





Effective
January 1, 2006, the Company adopted the fair value recognition provisions of
SFAS No. 123(R), using the modified prospective transition method and,
therefore, have not restated results for prior periods.





Share-based
compensation expense for all share-based compensation awards granted after
January 1, 2006, is based on the grant-date fair value. For all awards except
stock option awards, the grant date fair value is either the fair market value
per share or book value per share (corresponding to the type of stock awarded)
as of the grant date. For stock option awards, the grant date fair value is
estimated using the Black-Scholes option pricing model. For all awards, the
Company recognizes these compensation costs only for those shares expected to
vest on a straight-line basis over the requisite service period of the award,
for which we use the related vesting term. The Company estimates forfeiture
rates based on historical employee option exercise and employee termination
experience.





The
share-based compensation expense recognized in the consolidated statements of
income for the three and six month periods ended June 30, 2009 and 2008 is based
on awards ultimately expected to vest, and accordingly has been adjusted by the
amount of estimated forfeitures. SFAS No. 123(R) requires forfeitures to be
estimated at the time of grant and revised, if necessary, in subsequent periods
if actual forfeitures differ from those estimates.  Forfeitures were
estimated based partially on historical experience.




- 16
-









The
following table provides a summary of the expenses the Company has recognized
related to share-based compensation as well as the impact those expenses have
had on diluted earnings per share for the periods indicated below:





For
      the three months ended
                                              
                                              
                                              For
      the six months endedJune
      30,
                                              
                                              
                                              June
      30,(dollars
      in thousands except share and per share data)
                                              
                                              2009
                                              
                                              
                                              2008
                                              
                                              
                                              2009
                                              
                                              
                                              2008Share-based
      compensation expense:Stock
      option expense
                                              
                                              $
                                              42
                                              
                                              
                                              $
                                              52
                                              
                                              
                                              $
                                              86
                                              
                                              
                                              $
                                              101Restricted
      stock expense
                                              
                                              
                                              52
                                              
                                              
                                              
                                              3
                                              
                                              
                                              
                                              98
                                              
                                              
                                              
                                              66Total
      share-based compensation expense
                                              
                                              
                                              94
                                              
                                              
                                              $
                                              55
                                              
                                              
                                              
                                              184
                                              
                                              
                                              $
                                              167Total
      share-based compensation expense, net of tax
                                              
                                              $
                                              57
                                              
                                              
                                              $
                                              40
                                              
                                              
                                              $
                                              113
                                              
                                              
                                              $
                                              114Diluted
      shares outstanding
                                              
                                              
                                              7,866,962
                                              
                                              
                                              
                                              7,830,390
                                              
                                              
                                              
                                              7,778,371
                                              
                                              
                                              
                                              7,841,144Impact
      on diluted earnings per share
                                              
                                              $
                                              0.007
                                              
                                              
                                              $
                                              0.005
                                              
                                              
                                              $
                                              0.015
                                              
                                              
                                              $
                                              0.015Unrecognized
      compensation expense:Stock
      option expense
                                              
                                              $
                                              258
                                              
                                              
                                              $
                                              367Restricted
      stock expense
                                              
                                              
                                              368
                                              
                                              
                                              
                                              604Total
      unrecognized share-based compensation expense
                                              
                                              $
                                              626
                                              
                                              
                                              $
                                              971Total
      unrecognized share-based compensation expense, net of tax
                                              
                                              $
                                              380
                                              
                                              
                                              $
                                              597





At June
30, 2009, there was a total of $258 thousand of unrecognized compensation
expense related to non-vested stock option awards. That expense is expected to
be recognized over a weighted-average period of 1.8 years.





The
Company grants restricted share awards periodically for the benefit of
employees. These restricted shares generally “cliff vest” after five years of
issuance. Recipients of restricted shares have the right to vote all shares
subject to such grant, and receive all dividends with respect to such shares,
whether or not the shares have vested. Recipients do not pay any cash
consideration for the shares.  The total unrecognized compensation
expense related to restricted share awards at June 30, 2009 was $368 thousand.
That expense is expected to be recognized over the next 1.7 years.





The
aggregate intrinsic value in the table below represents the total pretax
intrinsic value (the difference between the Company’s closing stock price on the
last trading day of the second quarter of 2009 and the exercise price,
multiplied by the number of in-the-money options that would have been received
by the option holders had all option holders exercised their options on June 30,
2009).  The aggregate pretax intrinsic value is subject to change
based on the fair market value of the Company's stock. The aggregate intrinsic
value of options exercised for the three and six month periods ended June 30,
2009 was $22 thousand.  The aggregate intrinsic value of options
exercised during the three and six month periods ended June 30, 2008 was $72
thousand and $214 thousand, respectively.




- 17
-









The
following table provides a summary of the aggregate intrinsic value of options
outstanding and exercisable as well as options granted, exercised, and forfeited
during the year-to-date periods ended June 30, 2009 and 2008:





AverageWeighted
                                                    
                                                    
                                                    Remaining
                                                    
                                                    
                                                    TotalAverage
                                                    
                                                    
                                                    Contractual
                                                    
                                                    
                                                    IntrinsicNumber
      of
                                                    
                                                    
                                                    Exercise
                                                    
                                                    
                                                    Term
                                                    
                                                    
                                                    ValueShares
                                                    
                                                    
                                                    Price
                                                    
                                                    
                                                    (in
      years)
                                                    
                                                    
                                                    (in
      000's)Options
      outstanding, January 1, 2009
                                                    
                                                    
                                                    408,830
                                                    
                                                    
                                                    $
                                                    9.34Granted
                                                    
                                                    
                                                    30,324
                                                    
                                                    
                                                    
                                                    4.81Exercised
                                                    
                                                    
                                                    (10,050
                                                    )
                                                    
                                                    
                                                    3.73Forfeited
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    -Options
      outstanding, June 30, 2009
                                                    
                                                    
                                                    429,104
                                                    
                                                    
                                                    $
                                                    9.15
                                                    
                                                    
                                                    
                                                    4.34
                                                    
                                                    
                                                    $
                                                    288Exercisable
      at June 30, 2009
                                                    
                                                    
                                                    347,172
                                                    
                                                    
                                                    $
                                                    8.92
                                                    
                                                    
                                                    
                                                    3.28
                                                    
                                                    
                                                    $
                                                    245Options
      outstanding, January 1, 2008
                                                    
                                                    
                                                    463,160
                                                    
                                                    
                                                    $
                                                    8.36Granted
                                                    
                                                    
                                                    26,250
                                                    
                                                    
                                                    
                                                    11.48Exercised
                                                    
                                                    
                                                    (32,090
                                                    )
                                                    
                                                    
                                                    4.37Forfeited
                                                    
                                                    
                                                    (4,439
                                                    )
                                                    
                                                    
                                                    6.58Options
      outstanding, June 30, 2008
                                                    
                                                    
                                                    452,881
                                                    
                                                    
                                                    $
                                                    8.84
                                                    
                                                    
                                                    
                                                    4.41
                                                    
                                                    
                                                    $
                                                    906Exercisable
      at June 30, 2008
                                                    
                                                    
                                                    362,146
                                                    
                                                    
                                                    $
                                                    7.78
                                                    
                                                    
                                                    
                                                    3.37
                                                    
                                                    
                                                    $
                                                    904




During
the first quarter of 2009, the Company granted 25,000 options to various
non-management members of the Company’s Board of Directors.  Similar
grants were made to the Company’s Board of Directors during the first quarter of
2008.  The following table presents the assumptions used in the
calculation of the weighted average fair value of options granted during 2009
and 2008 on the date of grant using the Black-Scholes options pricing
model:





2009
                        
                        
                        2008Expected
      volatility
                        
                        
                        42.26
                        %
                        
                        
                        35.07
                        %Expected
      term (years)
                        
                        
                        10
                        
                        
                        
                        10Dividend
      yield
                        
                        
                        0.00
                        %
                        
                        
                        2.66
                        %Risk
      free rate
                        
                        
                        2.84
                        %
                        
                        
                        3.62
                        %Weighted-average
      grant date fair value
                        
                        $
                        2.74
                        
                        
                        $
                        3.93




The
Black-Scholes model incorporates a range of assumptions for inputs that are
disclosed in the table above.  Expected volatilities are based on,
among other things, the daily historical stock price over the expected life of
the option.  The expected term of options granted is derived from the
output of the model and represents the period of time that options granted are
expected to be outstanding.  Dividend yields are estimated based on
the dividend yield on the Company’s common stock at the time of
grant.  The risk-free rate for periods within the contractual life of
the stock option is based on the U.S. Treasury yield curve in effect at the time
of grant.





Estimates
of fair value derived from the Company’s use of the Black-Scholes pricing model
are theoretical values for stock options and changes in the assumptions used in
the models could result in different fair value estimates.  The actual
value of the stock options granted will depend on the market value of the
Company’s common stock when the options are exercised.




- 18
-









Note
7.  Fair Value Disclosures





Effective
January 1, 2008, the Company determines the fair market values of certain
financial instruments based on the fair value hierarchy established in SFAS No.
157,“Fair Value
Measurements,” which requires an entity to maximize the use of observable
inputs and minimize the use of unobservable inputs when measuring fair value.
The standard describes three levels of inputs that may be used to measure fair
value.





The
following provides a summary of the hierarchical levels, as defined by SFAS No.
157, used to measure fair value:





Level 1 -
Quoted prices in active markets for identical assets or liabilities that the
reporting entity has the ability to access at the measurement date. Level 1
assets and liabilities may include debt and equity securities that are traded in
an active exchange market and that are highly liquid and are actively traded in
over-the-counter markets.





Level 2 -
Observable inputs other than Level 1 prices, such as quoted prices for similar
assets or liabilities; quoted prices in markets that are not active; or other
inputs that are observable or can be corroborated by observable market data for
substantially the full term of the assets or liabilities. Level 2 assets and
liabilities may include debt securities with quoted prices that are traded less
frequently than exchange-traded instruments and other instruments whose value is
determined using a pricing model with inputs that are observable in the market
or can be derived principally from or corroborated by observable market data.
This category generally includes U.S. Government and agency mortgage-backed debt
securities, corporate debt securities, derivative contracts, residential
mortgage and loans held-for-sale.





Level 3 -
Unobservable inputs that are supported by little or no market activity and that
are significant to the fair value of the assets or liabilities. Level 3 assets
and liabilities include financial instruments whose value is determined using
pricing models, discounted cash flow methodologies, or similar techniques, as
well as instruments for which the determination of fair value requires
significant management judgment or estimation. This category generally includes
certain private equity investments, retained residual interests in
securitizations, residential MSRs, asset-backed securities (ABS), highly
structured or long-term derivative contracts and certain collateralized debt
obligations (CDO) where independent pricing information was not able to be
obtained for a significant portion of the underlying assets.





Fair
Value Measurements





The
Company used the following methods and significant assumptions to estimate fair
value:





Securities





The fair
value of securities available-for-sale are determined by obtaining quoted prices
on nationally recognized exchanges or matrix pricing which is a mathematical
technique used widely in the industry to value debt securities without relying
exclusively on quoted prices for the specific securities but rather relying on
the security’s relationship to other benchmark quoted securities.




Loans
Held For Sale





The fair
value of loans held for sale is determined, when possible, using quoted
secondary market prices. If no such quoted price exists, the fair value of the
loan is determined using quoted prices for a similar asset or assets, adjusted
for the specific attributes of that loan.




Impaired
Loans





A loan is
considered impaired when it is probable that payment of interest and principal
will not be made in accordance with the contractual terms of the loan
agreement.  Impairment is measured based on the fair value of the
underlying collateral or the discounted expected future cash
flows.  The Company measures impairment on all non-accruing loans for
which it has established specific reserves as part of the specific allocated
allowance component of the allowance for loan losses.  As such, the
Company records impaired loans as non-recurring Level 2 when the fair value of
the underlying collateral is based on an observable market price or current
appraised value.  When current market prices are not available or the
Company determines that the fair value of the underlying collateral is further
impaired below appraised values, the Company records impaired loans as
non-recurring Level 3.  At June 30, 2009, substantially all of the
Company’s impaired loans were evaluated based on the fair value of their
underlying collateral with the most recent appraisal available to
Management.




- 19
-









Other
Real Estate Owned and Foreclosed Collateral





Other
real estate owned and foreclosed collateral are adjusted to fair value, less any
estimated costs to sell, at the time the loans are transferred into this
category.  The fair value of these assets is based on independent
appraisals, observable market prices for similar assets, or Management’s
estimation of value.  When the fair value is based on independent
appraisals or observable market prices for similar assets, the Company records
other real estate owned or foreclosed collateral as non-recurring Level
2.  When appraised values are not available, there is no observable
market price for similar assets, or Management determines the fair value of the
asset is further impaired below appraised values or observable market prices,
the Company records other real estate owned or foreclosed collateral as
non-recurring Level 3.





The
following table provides a summary of the financial instruments the Company
measures at fair value on a recurring basis as of June 30, 2009:





Fair
      Value Measurments UsingAssets
      At(dollars
      in thousands)
                      
                      Level
      1
                      
                      
                      Level
      2
                      
                      
                      Level
      3
                      
                      
                      Fair
      ValueAssets:Available
      for sale investment securities
                      
                      $
                      -
                      
                      
                      $
                      74,988
                      
                      
                      $
                      738
                      
                      
                      $
                      75,726Total
      assets measured on a recurring basis
                      
                      $
                      -
                      
                      
                      $
                      74,988
                      
                      
                      $
                      738
                      
                      
                      $
                      75,726





The
following table provides a summary of the changes in balance sheet carrying
values associated with Level 3 financial instruments during the three months
ended June 30, 2009:





Available
      ForSale
      Investment(dollars
      in thousands)
                          
                          SecuritiesBeginning
      balance
                          
                          $
                          774Total
      gains or losses (realized/unrealized)(1):Included
      in earnings
                          
                          
                          -Included
      in other comprehensive loss
                          
                          
                          (36
                          )Purchases
                          
                          
                          -Transfers
      in and/or out of Level 3
                          
                          
                          -Ending
      balance
                          
                          $
                          738


(1)
Realized or unrealized gains from the changes in values of Level 3 financial
instruments represent gains from changes in values of financial instruments only
for the period(s) in which the instruments were classified as Level
3.





The
assets presented under level 3 of the fair value hierarchy described in SFAS No.
157 represent available for sale investment securities in the form of
certificates of participation where an active market for such securities is not
currently available.





The
following table provides a summary of the financial instruments the Company
measures at fair value on a non-recurring basis as of June 30,
2009:





Fair
      Value Measurments UsingAssets
      At(dollars
      in thousands)
                      
                      Level
      1
                      
                      
                      Level
      2
                      
                      
                      Level
      3
                      
                      
                      Fair
      ValueAssets:Impaired
      loans
                      
                      $
                      -
                      
                      
                      $
                      12,151
                      
                      
                      $
                      -
                      
                      
                      $
                      12,151Loans
      held for sale
                      
                      
                      -
                      
                      
                      
                      11,692
                      
                      
                      
                      -
                      
                      
                      
                      11,692Other
      real estate owned
                      
                      
                      -
                      
                      
                      
                      6,669
                      
                      
                      
                      -
                      
                      
                      
                      6,669Total
      assets measured on a non-recurring basis
                      
                      $
                      -
                      
                      
                      $
                      30,512
                      
                      
                      $
                      -
                      
                      
                      $
                      30,512




- 20
-




Notes to
Consolidated Financial Statements








In
addition to the assets presented in the table above, the Company uses fair value
measurements on a non-recurring basis in its assessment of assets classified as
Goodwill.  These assets are recorded at fair value initially and
assessed for impairment periodically thereafter.  During the fiscal
year ended December 31, 2008, the carrying amount of goodwill assets were
compared to their fair value.  No change in carrying amount resulted
in accordance with the provisions of SFAS No. 142, “Goodwill and Other Intangible
Assets.”  Additionally,
the Company has certain other loans that are measured at fair value on a
non-recurring basis such as loans that were acquired in the acquisition of
Business First National Bank.





Note
8.  Fair Value of Financial Instruments





The fair
value of a financial instrument is the amount at which the asset or obligation
could be exchanged in a current transaction between willing parties, other than
a forced or liquidation sale.  Fair value estimates are made at a
specific point in time based on relevant market information and information
about the financial instrument.  These estimates do not reflect any
premium or discount that could result from offering for sale at one time the
entire holdings or a particular financial instrument.  Because no
market value exists for a significant portion of the financial instruments, fair
value estimates are based on judgments regarding future expected loss
experience, current economic conditions, risk characteristics of various
financial instruments, and other factors.  These estimates are
subjective in nature, involve uncertainties and matters of judgment and,
therefore, cannot be determined with precision.  Changes in
assumptions could significantly affect these estimates.





Fair
value estimates are based on financial instruments both on and off the balance
sheet without attempting to estimate the value of anticipated future business
and the value of assets and liabilities that are not considered financial
instruments.  Additionally, tax consequences related to the
realization of the unrealized gains and losses can have a potential effect on
fair value estimates and have not been considered in many of the
estimates.





The
following table provides a summary of the estimated fair value of financial
instruments at June 30, 2009:





June 30, 2009Carrying(dollars
      in thousands)
                          
                          Amount
                          
                          
                          Fair ValueAssetsCash
      and cash equivalents
                          
                          $
                          48,342
                          
                          
                          $
                          48,342Interest
      bearing deposits
                          
                          
                          119
                          
                          
                          
                          119Investments
      and mortgage-backed securities
                          
                          
                          75,726
                          
                          
                          
                          75,726Federal
      Home Loan Bank and Federal Reserve Bank stock
                          
                          
                          5,828
                          
                          
                          
                          5,828Loans
      receivable, net of deferred fees and costs
                          
                          
                          696,299
                          
                          
                          
                          704,558Loans
      held for sale
                          
                          
                          11,692
                          
                          
                          
                          11,692Bank
      owned life insurance
                          
                          
                          10,949
                          
                          
                          
                          10,949Accrued
      interest receivable
                          
                          
                          3,298
                          
                          
                          
                          3,298LiabilitiesNon-interest
      bearing deposits
                          
                          
                          178,600
                          
                          
                          
                          178,600Interest
      bearing deposits
                          
                          
                          525,389
                          
                          
                          
                          522,268Federal
      Home Loan Bank advances
                          
                          
                          65,000
                          
                          
                          
                          65,246Junior
      subordinated debentures
                          
                          
                          13,403
                          
                          
                          
                          12,252Accrued
      interest payable
                          
                          
                          608
                          
                          
                          
                          608Notional
                          
                          
                          Cost
      to CedeAmount
                          
                          
                          or AssumeOff-balance
      sheet instruments, commitments to extend credit and standby letters of
      credit
                          
                          $
                          219,315
                          
                          
                          $
                          2,193





The
following methods and assumptions were used by the Company in estimating fair
values of financial instruments:





Cash
and Cash Equivalents





The
carrying amounts reported in the balance sheet for cash and cash equivalents
approximate the fair values of those assets due to the short-term nature of the
assets.


- 21
-




Notes to
Consolidated Financial Statements





Interest
Bearing Deposits and Accrued Interest Payable





The fair
values disclosed for interest bearing deposits (for example, interest-bearing
checking accounts and passbook accounts) are, by definition, equal to the amount
payable on demand at the reporting date (that is, their carrying
amounts).  The fair values for certificates of deposit are estimated
using a discounted cash flow analysis that applies interest rates currently
being offered on certificates to a schedule of aggregated contractual maturities
on such time deposits.





The
carrying amount of accrued interest payable approximates its fair
value.





Investments
Including Federal Home Loan Bank Stock, Federal Reserve Bank Stock and
Mortgage-Backed Securities





Fair
values are based upon quoted market prices, where available. If quoted market
prices are not available, fair values are extrapolated from the quoted prices of
similar instruments or through the use of other observable data supporting a
valuation model.  Fair values for holdings of Federal Home Loan Bank
and Federal Reserve Bank stock are based on carrying amounts.





Loans,
Loans Held for Sale, and Accrued Interest Receivable





For
variable-rate loans that re-price frequently and with no significant change in
credit risk, fair values are based on carrying amounts.  The fair
values for other loans (for example, fixed rate commercial real estate and
rental property mortgage loans and commercial and industrial loans) are
estimated using discounted cash flow analysis, based on interest rates currently
being offered for loans with similar terms to borrowers of similar credit
quality.  Loan fair value estimates include judgments regarding future
expected loss experience and risk characteristics.





The fair
value of loans held for sale is determined, when possible, using quoted
secondary market prices.  If no such quoted price exists, the fair
value of the loan is determined using quoted prices for a similar asset or
assets, adjusted for the specific attributes of that loan.





The
carrying amount of accrued interest receivable approximates its fair
value.





Bank
Owned Life Insurance





Fair
values are based on current cash surrender values at each reporting date
provided by the underlying insurers.





Federal
Home Loan Bank Advances





The fair
value disclosed for FHLB advances is determined by discounting contractual cash
flows at current market interest rates for similar instruments.





Junior
Subordinated Debentures





The fair
value disclosed for junior subordinated debentures is based on contractual cash
flows at current market interest rates for similar instruments.





Off-Balance
Sheet Instruments





Fair
values of commitments to extend credit and standby letters of credit are based
upon fees currently charged to enter into similar agreements, taking into
account the remaining terms of the agreement and the counterparties' credit
standing.


- 22
-




Notes to
Consolidated Financial Statements





Note
9.  Preferred Stock





On
February 27, 2009, the Company received shareholder approval for an amendment of
its Articles of Incorporation to add a class of preferred stock, which
ultimately allowed it to participate in the U.S Treasury’s Capital Purchase
Program (“CPP”).





Under its
Amended Articles of Incorporation, The Company is authorized to issue up to
5,000,000 shares of preferred stock, in one or more series, having such voting
powers, designations, preferences, rights, qualifications, limitations and
restrictions as determined by the Board of Directors.





On March
20, 2009, the Company issued 21,000 shares of Senior Preferred Stock to the U.S.
Treasury under the terms of the CPP for $21.0 million with a liquidation
preference of $1,000 per share.  The preferred stock will carry a
coupon of 5% for five years and 9% thereafter.  Senior preferred
issued to the U.S. Treasury will be non-voting, cumulative, and perpetual and
may be redeemed at 100% of their liquidation preference plus accrued and unpaid
dividends following three years from the date of issue.  In addition,
the Company issued a warrant to the U.S. treasury to purchase shares of the
Company’s common stock in an amount equal to 15% of the preferred equity
issuance or approximately $3.2 million (611,650 shares).  The warrant
is exercisable immediately at a price of $5.15 per share, will expire after a
period of 10 years from issuance and is transferable by the U.S.
Treasury.  The Company expects the warrant to be dilutive to earnings
per common share.





The U.S.
Treasury may not transfer a portion or portions of the warrant with respect to,
and/or exercise the warrant for more than one-half of, the 611,650 common shares
issuable upon exercise of the warrant, in the aggregate, until the earlier of
(i) the date on which the Company has received aggregate gross proceeds of
not less than $21.0 million from one or more Qualified Equity Offerings and
(ii) December 31, 2009.  However, if the Company were to redeem all of
the Senior Preferred Stock as permitted by and in accordance with the provisions
set forth under the CPP, the U.S. Treasury will be permitted, subject to
compliance with applicable securities laws, to transfer all or a portion of the
warrant with respect to, and/or exercise the warrant for, all or a portion of
the number of common shares issuable thereunder, at any time and without
limitation.  In the event the Company completes one or more Qualified
Equity Offerings on or prior to December 31, 2009, that result in the
Company receiving aggregate gross proceeds of not less than $21.0 million, the
number of the common shares underlying the portion of the warrant then held by
the U.S. Treasury will be reduced by one-half of the common shares originally
covered by the warrant.  The U.S. Treasury has agreed not to exercise
voting power with respect to any common shares issued to it upon exercise of the
warrant.   At June 30, 2009, there had been no changes to the
number of common shares covered by the warrant nor had the U.S. Treasury
exercised any portion of the warrant.





The
proceeds received from the U.S. Treasury were allocated to the Senior Preferred
Stock and the warrant based on their relative fair values.  The fair
value of the Senior Preferred Stock was determined through a discounted future
cash flow model at a discount rate of 10%.  The fair value of the
warrant was calculated using the Black-Scholes option pricing model, which
includes assumptions regarding the Company’s dividend yield, stock price
volatility, and the risk-free interest rate.  As a result the Company
recorded the Senior Preferred Stock and the warrant at approximately $19.2
million and $1.8 million, respectively.  The Company will accrete the
discount on the Senior Preferred Stock over a period of five years with
corresponding charges to retained earnings.





It is
also important to note that net income available to common shareholders will be
impacted to the extent the Company charges retained earnings for the accretion
of the discount on the Senior Preferred Stock and any dividends paid from
retained earnings on the Senior Preferred Stock.  For the three and
six month periods ended June 30, 2009, dividends and accretion on the Senior
Preferred Stock totaled approximately $250 thousand and $261 thousand,
respectively.





Additionally,
the Company is subject to certain limitations during its participation in the
CPP including:





·
            The
      requirement to obtain consent from the U.S. Treasury for any proposed
      increases in common stock dividends prior to the third anniversary date of
      the preferred equity issuance.





·
            The
      Senior Preferred Stock cannot be redeemed for three years unless the
      Company obtains proceeds to replace the Senior Preferred Stock through a
      qualified equity offering.





·
            The
      U.S. Treasury must consent to any buy back of our common
      stock.





·
            The
      Company must adhere to restrictions placed on the amount of and type of
      compensation paid to its executives while participating in the CPP,
      pursuant to section 111 of the Emergency Economic Stabilization Act of
      2008, as amended (“EESA”).




- 23
-




Notes to
Consolidated Financial Statements


Note
10.  Subsequent Events





During
the last few days of July 2009, the Bank finalized the sale of three OREO
properties and received proceeds of approximately $2.5 million.  In
connection with the sale of these properties, the Bank recognized an aggregate
pre tax loss on sale of approximately $0.3 million in the month of
July.





Note
11.  Reclassifications





Certain
amounts in the 2008 financial statements have been reclassified to conform to
the 2009 presentation.


- 24
-


Forward
Looking Statements





Certain
statements contained in this Quarterly Report on Form 10-Q (“Quarterly Report”),
including, without limitation, statements containing the words “believes”,
“anticipates”, “intends”, “expects”, and words of similar impact, constitute
“forward-looking statements” within the meaning of Section 27A of the Securities
Act of 1933 and Section 21E of the Securities and Exchange Act of 1934. Such
forward-looking statements involve known and unknown risks, uncertainties and
other factors that may cause the actual results, performance or achievements of
the Company to be materially different from any future results, performance or
achievements expressed or implied by such forward-looking statements. Such
factors include, among others, the following: the ongoing financial crisis in
the United States, and the response of the federal and state government and our
regulators thereto, general economic conditions and California’s energy crisis,
the recent fluctuations in U.S. markets resulting, in part, from problems
related to sub-prime lending, the recent downturn in the California real-estate
market, general economic and business conditions in those areas in which the
Company operates, demographic changes, competition, fluctuations in interest
rates, changes in business strategy or development plans, changes in
governmental regulation, credit quality, the availability of capital to fund the
expansion of the Company’s business, as well as economic, political and global
changes arising from the war on terrorism (Refer to the Company’s December 31,
2008 10-K, ITEM 1A. Risk Factors). The Company disclaims any obligation to
update any such factors or to publicly announce the results of any revisions to
any of the forward-looking statements contained herein to reflect future events
or developments.


- 25
-


Item
2.  Management’s Discussion and Analysis of Financial Condition and
Results of Operations





The
following is an analysis of the results of operations and financial condition of
the Company as of and for the three and six month periods ending June 30, 2009
and 2008.  The analysis should be read in connection with the
consolidated financial statements and notes thereto appearing elsewhere in this
report.





The
Company





Heritage
Oaks Bancorp (the "Company") is a California corporation organized in 1994 to
act as a holding company of Heritage Oaks Bank ("Bank"), a 15 branch bank
serving San Luis Obispo and Santa Barbara Counties.  In 1994, the
Company acquired all of the outstanding common stock of the Bank in a holding
company formation transaction.





In
October 2006, the Company formed Heritage Oaks Capital Trust II (“Trust II”).
Trust II is a statutory business trust formed under the laws of the State of
Delaware and is a wholly-owned, non-financial, non-consolidated subsidiary of
the Company.





In
September 2007, the Company formed Heritage Oaks Capital Trust III (“Trust
III”). Trust III is a statutory business trust formed under the laws of the
State of Delaware and is a wholly-owned, non-financial, non-consolidated
subsidiary of the Company.





On
October 12, 2007, the Company acquired Business First National Bank (“Business
First”).  Business First was merged with and into Heritage Oaks Bank,
a wholly owned subsidiary of the Company.  In connection with the
acquisition, two additional branches were added to the Bank’s
network.  For additional information regarding this acquisition,
please see Note 23 to the consolidated financial statements of the Company’s
2008 annual report, which was filed on Form 10-K.





Other
than holding the shares of the Bank, the Company conducts no significant
activities, although it is authorized, with the prior approval of the Board of
Governors of the Federal Reserve System (the "Federal Reserve Board"), the
Company's principal regulator, to engage in a variety of activities which are
deemed closely related to the business of banking. The Company has also caused
to be incorporated a subsidiary, CCMS Systems, Inc. which is currently inactive
and has not been capitalized. The Company has no present plans to activate the
proposed subsidiary.





Where
You Can Find More Information





Under the
Securities Exchange Act of 1934 Sections 13 and 15(d), periodic and current
reports must be filed with the SEC. The Company electronically files the
following reports with the SEC: Form 10-K (Annual Report), Form 10-Q (Quarterly
Report), Form 8-K (Current Report), and Form DEF 14A (Proxy Statement). The
Company may file additional forms. The SEC maintains an internet site,
www.sec.gov, in which all forms filed electronically may be accessed.
Additionally, all forms filed with the SEC and additional shareholder
information is available free of charge on the Company’s website:
www.heritageoaksbancorp.com.





The
Company posts these reports to its website as soon as reasonably practicable
after filing them with the SEC.  None of the information on or
hyperlinked from the Company’s website is incorporated into this Quarterly
Report on Form 10-Q.


- 26
-




Management’s
Discussion and Analysis


Executive
Summary





For the
three and six month periods ended June 30, 2009, earnings available to common
shareholders were approximately $0.3 million and $1.3 million,
respectively.  This when compared to the same periods ended a year
earlier represents a decline of approximately $0.4 million and $1.0 million,
respectively.  Earnings per diluted common share for the three and six
month periods ended June 30, 2009 were $0.03 and $0.17, respectively,
representing respective declines of $0.06 and $0.13 when compared to the same
periods ended a year earlier.  Year over year declines in earnings can
be attributed to elevated provisions for loan losses, a one time assessment
imposed by the FDIC and several one time charges incurred as a result of OREO
properties the Bank acquired.  The FDIC assessment was imposed on all
insured institutions with the intent to replenish the Deposit Insurance
Fund.  Additionally, during the second quarter of 2008 the Bank
recognized income related to the Visa, Inc. IPO in the approximate amount of
$0.3 million.  The absence of this income in the second quarter of
2009 is another factor behind the year over year decline in
earnings.





One time
charges during the first six months of 2009 include the special FDIC assessment
in the amount of $0.4 million, booked during the second quarter, and expenses
incurred related to OREO properties the Bank acquired in the amount of $0.2
million and $0.3 million for the three and six months ended June 30, 2009,
respectively.  Absent these charges, non-interest expenses would have
been approximately $0.1 million and $0.4 million lower that that reported for
the same three and six month periods ended a year earlier.  Management
has and will continue to focus on cost controls and efficiency gains while
navigating through this difficult economic environment.





Net
interest income for the three and six month periods ended June 30, 2009 showed
slight increases of $0.3 million and $0.7 million, respectively, when compared
to year ago levels.  Although interest income fell approximately $0.3
million and $1.2 million for the three and six month periods ended June 30, 2009
when compared to year ago levels, interest expenses fell at a faster pace,
allowing for the increases seen in net interest income.  Throughout
2008 and early 2009, the Bank stayed relatively short with respect to maturities
on various interest bearing liabilities, allowing the Bank the opportunity to
take advantage of lower rates in a rates down
environment.  Additionally, floors within the loan portfolio were
instrumental in abating any substantial year over year decline in interest
income.





Non-performing
assets at June 30, 2009 were approximately $18.9 million or $4.3 million lower
than that reported at March 31, 2009 and $1.1 million lower that that reported
at December 31, 2008.  Although approximately $6.7 million in loan
balances moved to OREO status during the second quarter, the Bank saw pay-downs
of approximately $1.2 million on non-accruing credits, the result of proceeds
obtained from the liquidation of collateral and principal
guarantees.  During the second quarter the Bank sold three spec
construction properties acquired through foreclosure for approximately $2.9
million.  In connection with the sale of these properties, the Bank
recognized a loss of approximately $104 thousand.  For the first six
months of 2009, losses on the sale of OREO totaled approximately $131 thousand.
As
discussed in Note 10. Subsequent Events, to the consolidated financial
statements, the Bank closed escrow for the sale of three additional OREO
properties in late July 2009.  In connection with the sale of these
properties, the Bank received aggregate proceeds of approximately $2.5 million
and recognized an aggregate pre-tax loss of approximately $0.3 million in July
2009.





Deposit
growth was strong during the first six months of the year, with total deposits
of $704.0 million at June 30, 2009, representing a $100.5 million or 16.6%
increase from that reported at December 31, 2008.  Net of brokered,
retail deposits grew approximately $110.6 million or 19.9% from that reported at
December 31, 2008.  Growth in deposit balances was driven in large
part by increases in non-interest bearing demand, retail money market deposits
and time certificates.  As a result of increased deposits, the Bank
was able to pay down approximately $46.0 million in brokered funds during the
second quarter and approximately $10.1 million on a year to date
basis.  Borrowings with the Federal Home Loan Bank (“FHLB”) declined
$44.0 million during the first six months of 2009, directly attributable to
growth in retail deposit balances.





The
following provides a summary of operating results for the three and six month
periods ended June 30, 2009 and 2008:





·
            Interest
      income for the three and six month periods ended June 30, 2009 was
      approximately $12.3 million and $24.2 million,
      respectively.  This, when compared to the $12.6 million and
      $25.4 million reported for the same periods ended a year earlier,
      represents declines of approximately $0.3 million and $1.2 million or 2.4%
      and 4.8%, respectively.  The year over year decline is primarily
      attributable to the actions taken by the Federal Reserve within the fourth
      quarter of 2008 to lower the overnight Fed Funds rate from 2.00%, as of
      June 30, 2008, to within a range of 0.00% and 0.25%.  However,
      as previously mentioned, floors in the loan portfolio were instrumental in
      mitigating any substantial year over year decline in interest
      income.





·
            Interest
      expenses for the three and six month periods ended June 30, 2009 were
      approximately $2.4 million and $4.8 million,
      respectively.  This, when compared to the $3.0 million and $6.7
      million reported for the same periods ended a year earlier, represents
      declines of approximately $0.6 million and $1.9 million or 18.7% and
      28.8%, respectively.  The year over year decline is mainly
      attributable to the dramatic declines in the overnight Fed Funds rate
      previously referred to above and the ability of the Bank to re-price a
      significant portion of its interest bearing liabilities over the last
      year.


- 27
-




Management’s
Discussion and Analysis





·
            Net
      interest income for the three and six months ended June 30, 2009 was
      approximately $9.8 million and $19.4 million,
      respectively.  When compared to the same periods ended a year
      earlier, this represents increases of approximately $0.3 million and $0.7
      million or 2.6% and 3.7%, respectively.  As previously
      mentioned, the ability of the Bank to re-price a significant portion of
      its interest bearing liabilities in a rates down environment contributed
      greatly to the year over year increases seen in net interest
      income.





·
            The
      net interest margin for the second quarter and the first six months of
      2009 was 4.91% and 4.97%, respectively.  When compared to the
      same periods a year earlier, this represents declines of approximately 37
      and 34 basis points, respectively.  Declines in the yields on
      earning assets when compared to year ago levels, contributed to the
      decline in the net interest margin.





·
            Non-interest
      income for the three and six months ended June 30, 2009 was approximately
      $1.5 million and $3.2 million, respectively.  This, when
      compared to the same periods ended a year earlier, represents declines
      of  $0.3 million and $35 thousand, respectively.  The
      year over year decline in the second quarter of 2009 can be attributed to
      income the Bank recognized in the second quarter of 2008 related to the
      Visa, Inc. IPO, totaling approximately $0.3
  million.





·
            Non-interest
      expenses for the three and six months ended June 30, 2009 were
      approximately $8.0 million and $15.4 million,
      respectively.  This, when compared to the $7.5 million and $15.1
      million reported for the same periods ended a year earlier, represents
      increases of approximately $0.5 million and $0.3 million or 6.9% and 2.1%,
      respectively.  As previously mentioned the Bank incurred several
      one time charges related to the special FDIC assessment and expenses
      related to OREO properties the Bank acquired.  Exclusive of
      these one time items, non-interest expenses would have been approximately
      $0.1 million and $0.4 million lower that that reported for the three and
      six month periods ended a year earlier,
  respectively.





The
following provides a summary for significant year to date changes in balances as
of June 30, 2009:





·
            At
      June 30, 2009, net loan balances were approximately $685.2 million or
      approximately $17.2 million and 2.6% higher than the $668.0 million
      reported at December 31, 2008.  See also “Loans” under
      “Financial Condition” of this discussion and analysis for additional
      information regarding the Bank’s loan
portfolio.





·
            At
      June 30, 2009, total deposits were approximately $704.0 million or
      approximately $100.5 million and 16.7% higher than the $603.5 million
      reported at December 31, 2008.  Deposits, exclusive of brokered
      were approximately $665.5 million or $110.6 million higher than the $554.9
      million reported at December 31, 2008.  See also “Deposits and
      Borrowed Funds” under “Financial Condition” of this discussion and
      analysis for information regarding the Bank’s deposit
      liabilities.





·
            At
      June 30, 2009, borrowings with the FHLB were $65.0 million or
      approximately $44.0 million lower than the $109.0 million reported at
      December 31, 2008.  Higher retail deposit balances during the
      first six months of 2009 resulted in fewer borrowings with the
      FHLB.





The
following provides an overview of asset quality as of June 30,
2009:





·
            At
      June 30, 2009, the balance of non-performing loans was approximately $12.2
      million or $6.5 million lower than the $18.7 million reported at December
      31, 2008.  As of June 30, 2009 the balance of non-performing
      loans as a percentage of total gross loans was 1.75% compared to 2.75% as
      of December 31, 2008.





·
            As
      of June 30, 2009, the allowance for loan losses represented 1.59% of total
      gross loans and 1.53% of total gross loans as of December 31,
      2008.





·
            During
      the three and six months ended June 30, 2009, the Bank made provisions to
      the allowance for loan losses in the approximate amount of $2.7 million
      and $4.8 million, respectively.  Charge-offs during the same
      periods were approximately $2.0 million and $4.1 million,
      respectively.





·
            For
      the three and six months ended June 30, 2009, net charge-offs to average
      gross loans were 0.29% and 0.59%, respectively.  When compared
      to the 0.14% and 0.16% reported for the same periods ended a year earlier,
      represents increases 15 and 43 basis points,
  respectively.




- 28
-




Management’s
Discussion and Analysis


·
            During
      the first six months of 2009, the Bank moved approximately $8.4 million in
      loan balances to OREO status of which approximately $6.7 million occurred
      during the second quarter of 2009.  As of June 30, 2009, the
      balance of OREO was $6.7 million compared to the $1.3 million reported at
      December 31, 2008.  In spite of the year to date increase in
      OREO balances, the Bank sold three spec construction properties during the
      second quarter in the aggregate amount of $2.9 million.  See
      also “Non Performing Assets” under “Financial Condition” of this
      discussion analysis for additional information related asset
      quality.





Recent
Developments




As previously mentioned andas
discussed in Note 10. Subsequent Events, to the consolidated financial
statements, the Bank closed escrow for the sale of three additional OREO
properties in late July 2009.  In connection with the sale of these
properties, the Bank received aggregate proceeds of approximately $2.5 million
and recognized an aggregate pre-tax loss of approximately $0.3 million in July
2009.





During
the third and fourth quarters of 2008, the credit and equity markets came under
significant duress as confidence by many in the U.S. financial system began to
wane.  During the later part of 2007 and throughout 2008, many U.S.
financial institutions were forced to significantly write-down the values of
certain classes of assets in response to the weakened real estate
market.  These losses lead to strained capital levels, impairing the
confidence of many depositors and others providing funding to the nation’s
banks, which in turn lead to a crisis of liquidity.  With liquidity
levels of many financial institutions significantly weakened, borrowing costs
began to rise considerably and the flow of credit to consumers and between banks
all but came to a halt.  In response to this, the weakened economy and
other factors, the U.S. Congress passes the Emergency Economic Stabilization Act
of 2008 (the “EESA”) in October of 2008.  Under the EESA, the
Department of the U.S. Treasury formed the Troubled Asset Relief Program (the
“TARP”).  The TARP gives the U.S. Treasury the power to make purchases
of certain troubled assets as well as the direct purchase of equity from U.S.
financial institutions under the CPP.  Although the Company’s
liquidity levels remained adequate and the Bank and Company were well
capitalized throughout 2008, the Company applied to participate in the CPP to
keep all capital raising options available.  On February 27, 2009, the
Company received shareholder approval to add an authorized class of preferred
stock to the Company’s Articles of Incorporation that allowed the Company to
participate in the CPP and will also allow for more flexibility in capital
raising efforts in general.  On March 20, 2009, the Company issued
21,000 shares of Senior Preferred Stock to the U.S. Treasury under the terms of
the CPP for $21.0 million.  Additionally, the Company issued a warrant
to the U.S. Treasury to purchase 611,650 shares of its common stock at a price
of $5.15 per share, representing 15% of the preferred issuance or approximately
$3.2 million.  For a more detailed discussion regarding the Company’s
participation in the CPP, see Note 9. Preferred Stock, to the consolidated
financial statements filed on this Form 10-Q.





Dividends
and Stock Repurchases





During
the second quarter of 2009, the Company paid approximately $160 thousand in
dividends on its Senior Preferred Stock issued to the U.S. Treasury under the
CPP.  See also Note 9. Preferred Stock, to the consolidated financial
statements filed on this form 10-Q for additional information about dividends on
the Company’s Senior Preferred Stock.





On April
24, 2008, the Board of Directors declared a 5% stock divided to be paid on May
16, 2008 to shareholders of record on May 2, 2008.  This stock
dividend represented a change in the form of dividend payment to the Company’s
shareholders away from cash dividends in order to retain the Company’s capital
for future growth.





On
January 24, 2008, the Board of Directors declared a quarterly cash dividend of
$0.08 per share to be paid on February 15, 2008 to shareholders of record on
February 1, 2008.





The
Company paid no dividends on or made repurchases of its common stock during the
three and six months ended June 30, 2009.


- 29
-




Management’s
Discussion and Analysis





Selected
Financial Data





The table
below provides selected financial data that highlights the Company’s quarterly
performance results:





For
      the quarters ended,(dollars
      in thousands except per share data)
                  
                  06/30/09
                  
                  
                  03/31/09
                  
                  
                  12/31/08
                  
                  
                  09/30/08
                  
                  
                  06/30/08
                  
                  
                  03/31/08
                  
                  
                  12/31/07
                  
                  
                  09/30/07Return
      on average assets
                  
                  
                  0.23
                  %
                  
                  
                  0.54
                  %
                  
                  
                  -0.63
                  %
                  
                  
                  0.27
                  %
                  
                  
                  0.35
                  %
                  
                  
                  0.91
                  %
                  
                  
                  1.11
                  %
                  
                  
                  1.12
                  %Return
      on average equity
                  
                  
                  2.20
                  %
                  
                  
                  6.04
                  %
                  
                  
                  -6.93
                  %
                  
                  
                  2.94
                  %
                  
                  
                  3.84
                  %
                  
                  
                  9.55
                  %
                  
                  
                  11.65
                  %
                  
                  
                  12.09
                  %Return
      on average common equity
                  
                  
                  1.41
                  %
                  
                  
                  6.19
                  %
                  
                  
                  -6.93
                  %
                  
                  
                  2.94
                  %
                  
                  
                  3.84
                  %
                  
                  
                  9.55
                  %
                  
                  
                  11.65
                  %
                  
                  
                  12.09
                  %Average
      equity to average assets
                  
                  
                  10.68
                  %
                  
                  
                  8.95
                  %
                  
                  
                  9.06
                  %
                  
                  
                  9.16
                  %
                  
                  
                  9.14
                  %
                  
                  
                  9.48
                  %
                  
                  
                  9.49
                  %
                  
                  
                  9.27
                  %Average
      common equity to average assets
                  
                  
                  8.47
                  %
                  
                  
                  8.64
                  %
                  
                  
                  9.06
                  %
                  
                  
                  9.16
                  %
                  
                  
                  9.14
                  %
                  
                  
                  9.48
                  %
                  
                  
                  9.49
                  %
                  
                  
                  9.27
                  %Net
      interest margin
                  
                  
                  4.91
                  %
                  
                  
                  5.03
                  %
                  
                  
                  5.04
                  %
                  
                  
                  5.18
                  %
                  
                  
                  5.28
                  %
                  
                  
                  5.33
                  %
                  
                  
                  5.33
                  %
                  
                  
                  5.44
                  %Efficiency
      ratio*
                  
                  
                  70.02
                  %
                  
                  
                  66.71
                  %
                  
                  
                  66.43
                  %
                  
                  
                  64.40
                  %
                  
                  
                  66.31
                  %
                  
                  
                  72.17
                  %
                  
                  
                  67.26
                  %
                  
                  
                  66.89
                  %Average
      loans to average deposits
                  
                  
                  103.58
                  %
                  
                  
                  112.39
                  %
                  
                  
                  109.95
                  %
                  
                  
                  111.54
                  %
                  
                  
                  109.26
                  %
                  
                  
                  103.64
                  %
                  
                  
                  96.40
                  %
                  
                  
                  95.79
                  %Net
      Income
                  
                  $
                  507
                  
                  
                  $
                  1,102
                  
                  
                  $
                  (1,254
                  )
                  
                  $
                  534
                  
                  
                  $
                  691
                  
                  
                  $
                  1,675
                  
                  
                  $
                  1,978
                  
                  
                  $
                  1,628Net
      income available to common shareholders
                  
                  $
                  257
                  
                  
                  $
                  1,091
                  
                  
                  $
                  (1,254
                  )
                  
                  $
                  534
                  
                  
                  $
                  691
                  
                  
                  $
                  1,675
                  
                  
                  $
                  1,978
                  
                  
                  $
                  1,628Earnings
      Per Common Share:Basic
                  
                  $
                  0.03
                  
                  
                  $
                  0.14
                  
                  
                  $
                  (0.16
                  )
                  
                  $
                  0.07
                  
                  
                  $
                  0.09
                  
                  
                  $
                  0.22
                  
                  
                  $
                  0.26
                  
                  
                  $
                  0.24Diluted
                  
                  $
                  0.03
                  
                  
                  $
                  0.14
                  
                  
                  $
                  (0.16
                  )
                  
                  $
                  0.07
                  
                  
                  $
                  0.09
                  
                  
                  $
                  0.21
                  
                  
                  $
                  0.25
                  
                  
                  $
                  0.23Outstanding
      Shares:Basic
                  
                  
                  7,696,027
                  
                  
                  
                  7,689,317
                  
                  
                  
                  7,660,342
                  
                  
                  
                  7,709,600
                  
                  
                  
                  7,705,174
                  
                  
                  
                  7,694,546
                  
                  
                  
                  7,682,730
                  
                  
                  
                  6,796,286Diluted
                  
                  
                  7,866,962
                  
                  
                  
                  7,824,377
                  
                  
                  
                  7,721,460
                  
                  
                  
                  7,798,321
                  
                  
                  
                  7,830,390
                  
                  
                  
                  7,851,831
                  
                  
                  
                  7,887,206
                  
                  
                  
                  7,013,070





* The
efficiency ratio is defined as total non interest expense as a percent of the
combined net interest income plus non interest income, exclusive of gains and
losses on the sale of investment securities and sale of other real estate
owned.





Local
Economy





The
economy in the Company’s service area is based primarily on agriculture,
tourism, light industry, oil and retail trade. Services supporting these
industries have also developed in the areas of medical, financial and
educational services.  The population of San Luis Obispo County, the
City of Santa Maria (in Northern Santa Barbara County), and the City of Santa
Barbara totaled approximately 262,000, 86,000, and 86,000 respectively,
according to the most recent economic data provided by the U.S. Census
Bureau.  The moderate climate allows a year round growing season for
numerous vegetables and fruits.  Vineyards and cattle ranches also
contribute largely to the local economy.  The Central Coast’s leading
agricultural industry is the production of wine grapes and production of premium
quality wines. Vineyards in production have grown significantly over the past
several years throughout the Company’s service area.  Access to
numerous recreational activities including lakes, mountains and beaches, provide
a relatively stable tourist industry from many areas including the Los
Angeles/Orange County basin, the San Francisco Bay area and the San Joaquin
Valley. While the economy in the Company’s primary markets of San Luis Obispo
and Santa Barbara counties have not been immune to the negative impacts of both
the national and state economies, the abundant tourism that has developed over
the past decade in our market area, especially in the wine industry and coastal
communities, has helped sustain our local economy in previous economic
downturns.  According to a recent publication by Smith Travel Research
in regard to hotel occupancy rates comparing May 2009 to May 2008, there was a
decline in occupancy of 2.6%, 4.9% and 12.3% for Paso Robles/San Luis Obispo,
Santa Barbara/Santa Maria and the State of California,
respectively.


- 30
-




Management’s
Discussion and Analysis


2008
proved to be a challenging year not only on the national level, but within the
state of California and more specifically our primary market area.  As
the U.S. housing market continued to wane throughout 2008 and economic growth
began to significantly slow, the ability of borrowers to satisfy their
obligations to the financial sector began to languish.  These among
other factors placed severe stress on the U.S. financial system, leading to a
crisis of confidence, further downturn in economic growth and unprecedented
volatility in the U.S. equity and credit markets.  As mentioned, our
primary market area has historically enjoyed a more stable level of economic
activity; however we believe these more macro level concerns have started to
become more evident within our market area.  Recent indications show
the unemployment rate within California to be approximately
11.5%.  Within the Company’s primary market area, recent indications
show the unemployment rate within San Luis Obispo and Santa Barbara major
metropolitan areas to be approximately 8.4% and 7.6%,
respectively.  Additionally, housing prices have fallen significantly
year over year within California, showing an approximate 42% year over year
decline as of December 2008.  Within the Company’s primary market,
housing prices have fallen in San Luis Obispo and Santa Barbara counties from
year ago levels by approximately 17% and 27%, respectively.  However,
sales have been relatively strong within the State of California and the
Company’s primary market area, climbing over 30% compared to 2008, the majority
of which can be attributed to sales of distressed properties.  That
said, the lack of oversupply in the Company’s market, desirable climate, close
proximity to beaches, lakes and the wine industry, for both San Luis Obispo and
Santa Barbara Counties have resulted in lower percentage declines in prices for
the local real-estate market, relative to other areas of
California.





Critical
Accounting Policies





The
Company’s significant accounting policies are set forth in the 2008 Annual
Report, Note 1 of the consolidated financial statements, which was filed on Form
10-K.





The
following is a brief description of the Company’s current accounting policies
involving significant Management valuation judgments.





Loans
and Interest on Loans





Loans
receivable that Management has the intent and ability to hold for the
foreseeable future or until maturity or payoff are reported at their outstanding
unpaid principal balances reduced by any charge-offs of specific valuation
accounts and net of any deferred fees or costs on originated loans, or
unamortized premiums or discounts on purchased loans.





Loan
origination fees and certain direct origination costs are capitalized and
recognized as an adjustment in yield of the related loan.





Loans on
which the accrual of interest has been discontinued are designated as
non-accrual loans.  The accrual of interest on loans is discontinued
when principal or interest is past due 90 days based on contractual terms of the
loan or when, in the opinion of Management, there is reasonable doubt as to
collectibility.  When loans are placed on non-accrual status, all
interest previously accrued but not collected is reversed against current period
interest income.  Interest income generally is not recognized on
specific impaired loans unless the likelihood of further loss is
remote.  Interest payments received on such loans are applied as a
reduction to the loan principal balance.  Interest accruals are
resumed on such loans only when they are brought current with respect to
interest and principal and when, in the judgment of Management, the loans are
estimated to be fully collectible as to all principal and interest.





The
Company considers a loan to be impaired when it is probable that the Company
will be unable to collect all amounts due (principal and interest) according to
the contractual terms of the loan agreement.  Measurement of
impairment is based on the expected future cash flows of an impaired loan which
are to be discounted at the loan’s effective interest rate, or measured by
reference to an observable market value, if one exists, or the fair value of the
collateral for a collateral-dependent loan.  The Company selects the
measurement method on a loan-by-loan basis except that collateral-dependent
loans for which foreclosure is probable are measured at the fair value of the
collateral.  The Bank recognizes interest income on impaired loans
based on its existing methods of recognizing interest income on non-accrual
loans.  All loans are generally charged off at such time the loan is
classified as a loss.





Allowance
for Loan Losses





The
allowance for loan losses is maintained at a level which, in Management's
judgment, is adequate to absorb credit losses inherent in the loan
portfolio.  The amount of the allowance is based on Management's
evaluation of the collectibility of the loan portfolio, including the nature and
volume of the portfolio, credit concentrations, trends in historical loss
experience, the level of certain classified balances and specific impaired
loans, and economic conditions and the related impact on specific borrowers and
industry groups.  The allowance is increased by a provision for loan
losses, which is charged to earnings and reduced by charge-offs, net of
recoveries.  Changes in the allowance relating to impaired loans are
charged or credited to the provision for loan losses.  Because of
uncertainties inherent in the estimation process, Management’s estimate of
credit losses inherent in the loan portfolio and the related allowance may
change.


- 31
-




Management’s
Discussion and Analysis





Loans are
considered impaired if, based on current information and events, it is probable
that we will be unable to collect the scheduled payments of principal or
interest when due according to the contractual terms of the loan
agreement.  The measurement of impaired loans is generally based on
the present value of expected future cash flows discounted at the historical
effective interest rate stipulated in the loan agreement, except that all
collateral-dependent loans are measured for impairment based on the fair value
of the collateral.  In measuring the fair value of the collateral,
Management uses assumptions and methodologies consistent with those that would
be utilized by unrelated third parties.  Allowances for impaired loans
are generally determined based on collateral values or the present value of
estimated cash flows.





As
mentioned, changes in the financial condition of individual borrowers, economic
conditions, historical loss experience and the condition of the various markets
in which collateral may be sold may all affect the required level of the
allowance for loan losses and the associated provision for loan
losses.





Other
Real Estate Owned





Real
estate and other property acquired in full or partial settlement of loan
obligations is referred to as other real estate owned (“OREO”).  OREO
is originally recorded in the Company’s financial statements at fair value less
any estimated costs to sell.  When property is acquired through
foreclosure or surrendered in lieu of foreclosure, the Company measures the fair
value of the property acquired against its recorded investment in the
loan.  If the fair value of the property at the time of acquisition is
less than the recorded investment in the loan, the difference is charged to the
allowance for loan losses.  Any subsequent fluctuations in the fair
value of OREO are recorded against a valuation allowance for foreclosed assets,
established through a charge to non-interest expense.  All related
operating or maintenance costs are charged to non-interest expense as incurred.
Any subsequent gains or losses on the sale of OREO are recorded in other income
or expense as incurred.





Securities
Available for Sale





In
accordance with SFAS No. 115, "Accounting for Certain Investments
in Debt and Equity Securities," which addresses the accounting for
investments in equity securities that have readily determinable fair values and
for investments in all debt securities,  securities  are
classified in three categories and accounted for as follows:  debt and
mortgage-backed securities that the Company has the positive intent and ability
to hold to maturity are classified as held-to-maturity and are measured at
amortized cost; debt and equity securities bought and held principally for the
purpose of selling in the near term are classified as trading securities and are
measured at fair value, with unrealized gains and losses included in earnings;
debt and equity securities not classified as either held-to-maturity or trading
securities are deemed as available-for-sale and are measured at fair value, with
unrealized gains and losses, net of applicable taxes, reported in a separate
component of stockholders' equity.  The fair values of most securities
that are designated available for sale are based on quoted market
prices.  If quoted market prices are not available, fair values are
extrapolated from the quoted prices of similar instruments or through the use of
other observable data supporting a valuation model.  Gains or losses
on sales of investment securities are determined on the specific identification
method.  Premiums and discounts are amortized or accreted using the
interest method over the expected lives of the related securities.





Declines
in the fair values of individual held-to-maturity and available-for-sale
securities below their cost that are other than temporary result in write-downs
of individual securities to their fair value.  The related write-downs
are included in earnings as realized losses. In estimating other-than-temporary
impairment losses, Management considers: (1) the length of time the security has
been in an unrealized loss position, (2) the extent to which the security’s fair
value is less than its cost, (3) the financial condition of the issuer, (4) any
adverse changes in ratings issued by various rating agencies, (5) the intent and
ability of the Bank to hold such securities for a period of time sufficient to
allow for any anticipated recovery in fair value and (6) in the case of mortgage
related securities, current cash flows, credit enhancements, loan-to-values,
credit scores, delinquency and default rates.





Goodwill
and Other Intangible Assets





As
discussed in the 2008 Annual Report, Note 1 of the consolidated financial
statements, which was filed on Form 10-K, we assess goodwill and other
intangible assets each year for impairment.  The Company’s assessment
at December 31, 2008, pursuant to its Goodwill Impairment Testing Policy, was
performed with the assistance of an independent third party and resulted in no
impairment.


- 32
-




Management’s
Discussion and Analysis





Results
of Operations





The
Company’s earnings are highly influenced by changes in short term interest
rates.  The nature of the Company’s balance sheet can be summarily
described as of short duration and asset sensitive. The balance sheet is of
short duration because a large percentage of its interest sensitive assets and
liabilities re-price immediately with changes in Federal Funds and Prime
interest rates.  This was evidenced during 2008, as the Federal Open
Market Committee (“FOMC”) cut the overnight Fed Funds rate by over 400 basis
points, placing pressure on the level of and growth in net interest
income.





Contributing
significantly to an asset sensitive balance sheet is a relatively large volume
of non-interest bearing demand deposit accounts which effectively never
re-price.  Therefore, an upward movement in short term interest rates
will generally result in higher net interest margin and conversely, a reduction
in short term interest rates will result in reduced net interest
margin.  However, as a result of promotions in the last two years
designed to attract lower cost core deposits, the Bank was able to significantly
increase the level of floating rate liabilities in the form of money market and
short term certificate accounts, bringing the balance sheet to a more neutral
position regarding interest rate sensitivity.  This was instrumental
in mitigating substantial year over year declines in the net interest margin as
a result of dramatic declines in the overnight Fed Funds and Prime rates during
2008.





For the
three and six months ended June 30, 2009 and 2008, the net interest margin was
4.91%, 4.97%, 5.28% and 5.31%, respectively.  The year over year
declines in the net interest margin can be attributed to reductions in the
overnight Fed Funds rate as well as higher average balances of federal funds
sold, resulting from substantial increases in core deposit balances during the
first six months of 2009.  Although higher average balances of federal
funds sold significantly enhanced the Bank’s liquidity position, it did
contribute somewhat to a lower yield on earning assets. On a year-over-year
rate/volume basis, the decrease in yield on earning assets overall was the
driver in regard to margin compression.





Historically,
the largest and most variable source of income for the Company is net interest
income. The results of operations for the three and six months ended June 30,
2009 and 2008 reflect the impact of dramatically lower interest rates throughout
the majority of 2008 as the result of a significantly weakened
economy.





Net
Interest Income and Margin





Net
interest income, the primary component of the net earnings of a financial
institution, refers to the difference between the interest paid on deposits and
borrowings, and the interest earned on loans and investments.  The net
interest margin is the amount of net interest income expressed as a percentage
of average earning assets. Factors considered in the analysis of net interest
income are the composition and volume of earning assets and interest-bearing
liabilities, the amount of non-interest bearing liabilities and non-accrual
loans, and changes in market interest rates.


- 33
-




Management’s
Discussion and Analysis





The
tables below set forth average balance sheet information, interest income and
expense, average yields and rates and net interest income and margin for the
three and six month periods ended June 30, 2009 and 2008. The average balance of
non-accruing loans has been included in loan totals:





For
      the three months ending
                                
                                
                                For
      the three months endingJune
      30, 2009
                                
                                
                                June
      30, 2008Yield/
                                
                                
                                Income/
                                
                                
                                
                                
                                
                                Yield/
                                
                                
                                Income/(dollars
      in thousands)
                                
                                Balance
                                
                                
                                Rate
      (4)
                                
                                
                                Expense
                                
                                
                                Balance
                                
                                
                                Rate
      (4)
                                
                                
                                ExpenseInterest
      Earning Assets:Investments
      with other banks
                                
                                $
                                119
                                
                                
                                
                                3.37
                                %
                                
                                $
                                1
                                
                                
                                $
                                281
                                
                                
                                
                                4.29
                                %
                                
                                $
                                3Federal
      funds sold
                                
                                
                                20,816
                                
                                
                                
                                0.19
                                %
                                
                                
                                10
                                
                                
                                
                                9,249
                                
                                
                                
                                1.96
                                %
                                
                                
                                45Investment
      securities taxable
                                
                                
                                57,746
                                
                                
                                
                                4.40
                                %
                                
                                
                                634
                                
                                
                                
                                46,594
                                
                                
                                
                                5.26
                                %
                                
                                
                                609Investment
      securities non taxable
                                
                                
                                19,412
                                
                                
                                
                                4.30
                                %
                                
                                
                                208
                                
                                
                                
                                17,423
                                
                                
                                
                                4.27
                                %
                                
                                
                                185Loans
      (1) (2)
                                
                                
                                705,779
                                
                                
                                
                                6.49
                                %
                                
                                
                                11,416
                                
                                
                                
                                656,917
                                
                                
                                
                                7.18
                                %
                                
                                
                                11,732Total
      interest earning assets
                                
                                
                                803,872
                                
                                
                                
                                6.12
                                %
                                
                                
                                12,269
                                
                                
                                
                                730,464
                                
                                
                                
                                6.92
                                %
                                
                                
                                12,574Allowance
      for possible loan losses
                                
                                
                                (10,121
                                )
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                (6,475
                                )Other
      assets
                                
                                
                                71,936
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                67,083Total
      assets
                                
                                $
                                865,687
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                $
                                791,072Interest
      Bearing Liabilities:Interest
      bearing demand
                                
                                $
                                61,084
                                
                                
                                
                                0.69
                                %
                                
                                $
                                105
                                
                                
                                $
                                83,754
                                
                                
                                
                                0.78
                                %
                                
                                $
                                160Savings
                                
                                
                                23,819
                                
                                
                                
                                0.19
                                %
                                
                                
                                11
                                
                                
                                
                                24,343
                                
                                
                                
                                0.59
                                %
                                
                                
                                36Money
      market
                                
                                
                                177,585
                                
                                
                                
                                1.48
                                %
                                
                                
                                656
                                
                                
                                
                                187,616
                                
                                
                                
                                1.76
                                %
                                
                                
                                824Time
      deposits
                                
                                
                                185,078
                                
                                
                                
                                2.52
                                %
                                
                                
                                1,161
                                
                                
                                
                                136,709
                                
                                
                                
                                3.14
                                %
                                
                                
                                1,068Brokered
      money market funds
                                
                                
                                32,893
                                
                                
                                
                                0.82
                                %
                                
                                
                                67
                                
                                
                                
                                -
                                
                                
                                
                                0.00
                                %
                                
                                
                                -Brokered
      time deposits
                                
                                
                                36,907
                                
                                
                                
                                1.46
                                %
                                
                                
                                134
                                
                                
                                
                                15,919
                                
                                
                                
                                3.28
                                %
                                
                                
                                131Total
      interest bearing deposits
                                
                                
                                517,366
                                
                                
                                
                                1.65
                                %
                                
                                
                                2,134
                                
                                
                                
                                448,341
                                
                                
                                
                                1.99
                                %
                                
                                
                                2,219Federal
      funds purchased
                                
                                
                                109
                                
                                
                                
                                1.10
                                %
                                
                                
                                -
                                
                                
                                
                                3,439
                                
                                
                                
                                2.46
                                %
                                
                                
                                21Securities
      sold under agreement to repurchase
                                
                                
                                -
                                
                                
                                
                                0.00
                                %
                                
                                
                                -
                                
                                
                                
                                2,094
                                
                                
                                
                                1.92
                                %
                                
                                
                                10Federal
      Home Loan Bank borrowing
                                
                                
                                68,956
                                
                                
                                
                                0.83
                                %
                                
                                
                                143
                                
                                
                                
                                90,731
                                
                                
                                
                                2.46
                                %
                                
                                
                                555Junior
      subordinated debentures
                                
                                
                                13,403
                                
                                
                                
                                4.49
                                %
                                
                                
                                150
                                
                                
                                
                                13,403
                                
                                
                                
                                5.40
                                %
                                
                                
                                180Total
      borrowed funds
                                
                                
                                82,468
                                
                                
                                
                                1.43
                                %
                                
                                
                                293
                                
                                
                                
                                109,667
                                
                                
                                
                                2.81
                                %
                                
                                
                                766Total
      interest bearing liabilities
                                
                                
                                599,834
                                
                                
                                
                                1.62
                                %
                                
                                
                                2,427
                                
                                
                                
                                558,008
                                
                                
                                
                                2.15
                                %
                                
                                
                                2,985Non
      interest bearing demand
                                
                                
                                163,994
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                152,927Total
      funding
                                
                                
                                763,828
                                
                                
                                
                                1.27
                                %
                                
                                
                                2,427
                                
                                
                                
                                710,935
                                
                                
                                
                                1.69
                                %
                                
                                
                                2,985Other
      liabilities
                                
                                
                                9,372
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                7,856Total
      liabilities
                                
                                $
                                773,200
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                $
                                718,791Stockholders'
      Equity:Preferred
      stock
                                
                                $
                                19,197
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                $
                                -Common
      stock
                                
                                
                                48,674
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                46,291Additional
      paid in capital
                                
                                
                                3,032
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                824Retained
      earnings
                                
                                
                                23,543
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                25,129Valuation
      allowance investments
                                
                                
                                (1,959
                                )
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                37Total
      stockholders' equity
                                
                                
                                92,487
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                72,281Total
      liabilities and stockholders' equity
                                
                                $
                                865,687
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                $
                                791,072Net
      interest income
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                $
                                9,842
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                $
                                9,589Net
      interest margin (3)
                                
                                
                                
                                
                                
                                
                                4.91
                                %
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                
                                5.28
                                %





(1)
            Nonaccrual
      loans have been included in total
loans.


(2)
            Loan
      fees of $225 and $369 for the three months ending June 30, 2009 and 2008,
      respectively have been included in interest income
      computation.


(3)
            Net
      interest margin has been calculated by dividing the net interest income by
      total average earning assets.


(4)
            Yield
      / Rate is annualized using actual number of days in
  period.




- 34
-




Management’s
Discussion and Analysis








For
      the six months ending
                                                                              
                                                                              
                                                                              For
      the six months endingJune
      30, 2009
                                                                              
                                                                              
                                                                              June
      30, 2008Yield/
                                                                              
                                                                              
                                                                              Income/
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              Yield/
                                                                              
                                                                              
                                                                              Income/(dollars
      in thousands)
                                                                              
                                                                              Balance
                                                                              
                                                                              
                                                                              Rate
      (4)
                                                                              
                                                                              
                                                                              Expense
                                                                              
                                                                              
                                                                              Balance
                                                                              
                                                                              
                                                                              Rate
      (4)
                                                                              
                                                                              
                                                                              ExpenseInterest
      Earning Assets:Investments
      with other banks
                                                                              
                                                                              $
                                                                              119
                                                                              
                                                                              
                                                                              
                                                                              3.39
                                                                              %
                                                                              
                                                                              $
                                                                              2
                                                                              
                                                                              
                                                                              $
                                                                              306
                                                                              
                                                                              
                                                                              
                                                                              3.94
                                                                              %
                                                                              
                                                                              $
                                                                              6Federal
      funds sold
                                                                              
                                                                              
                                                                              16,852
                                                                              
                                                                              
                                                                              
                                                                              0.20
                                                                              %
                                                                              
                                                                              
                                                                              17
                                                                              
                                                                              
                                                                              
                                                                              8,631
                                                                              
                                                                              
                                                                              
                                                                              2.61
                                                                              %
                                                                              
                                                                              
                                                                              112Investment
      securities taxable
                                                                              
                                                                              
                                                                              51,507
                                                                              
                                                                              
                                                                              
                                                                              4.66
                                                                              %
                                                                              
                                                                              
                                                                              1,189
                                                                              
                                                                              
                                                                              
                                                                              42,370
                                                                              
                                                                              
                                                                              
                                                                              5.13
                                                                              %
                                                                              
                                                                              
                                                                              1,081Investment
      securities non taxable
                                                                              
                                                                              
                                                                              18,293
                                                                              
                                                                              
                                                                              
                                                                              4.34
                                                                              %
                                                                              
                                                                              
                                                                              394
                                                                              
                                                                              
                                                                              
                                                                              17,273
                                                                              
                                                                              
                                                                              
                                                                              4.30
                                                                              %
                                                                              
                                                                              
                                                                              369Loans
      (1) (2)
                                                                              
                                                                              
                                                                              700,804
                                                                              
                                                                              
                                                                              
                                                                              6.49
                                                                              %
                                                                              
                                                                              
                                                                              22,563
                                                                              
                                                                              
                                                                              
                                                                              640,449
                                                                              
                                                                              
                                                                              
                                                                              7.48
                                                                              %
                                                                              
                                                                              
                                                                              23,823Total
      interest earning assets
                                                                              
                                                                              
                                                                              787,575
                                                                              
                                                                              
                                                                              
                                                                              6.19
                                                                              %
                                                                              
                                                                              
                                                                              24,165
                                                                              
                                                                              
                                                                              
                                                                              709,029
                                                                              
                                                                              
                                                                              
                                                                              7.20
                                                                              %
                                                                              
                                                                              
                                                                              25,391Allowance
      for possible loan losses
                                                                              
                                                                              
                                                                              (10,370
                                                                              )
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              (6,339
                                                                              )Other
      assets
                                                                              
                                                                              
                                                                              69,431
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              64,924Total
      assets
                                                                              
                                                                              $
                                                                              846,636
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              $
                                                                              767,614Interest
      Bearing Liabilities:Interest
      bearing demand
                                                                              
                                                                              $
                                                                              62,845
                                                                              
                                                                              
                                                                              
                                                                              0.61
                                                                              %
                                                                              
                                                                              $
                                                                              189
                                                                              
                                                                              
                                                                              $
                                                                              75,314
                                                                              
                                                                              
                                                                              
                                                                              0.68
                                                                              %
                                                                              
                                                                              $
                                                                              255Savings
                                                                              
                                                                              
                                                                              22,949
                                                                              
                                                                              
                                                                              
                                                                              0.18
                                                                              %
                                                                              
                                                                              
                                                                              20
                                                                              
                                                                              
                                                                              
                                                                              28,634
                                                                              
                                                                              
                                                                              
                                                                              1.17
                                                                              %
                                                                              
                                                                              
                                                                              166Money
      market
                                                                              
                                                                              
                                                                              175,378
                                                                              
                                                                              
                                                                              
                                                                              1.51
                                                                              %
                                                                              
                                                                              
                                                                              1,316
                                                                              
                                                                              
                                                                              
                                                                              195,860
                                                                              
                                                                              
                                                                              
                                                                              2.16
                                                                              %
                                                                              
                                                                              
                                                                              2,105Time
      deposits
                                                                              
                                                                              
                                                                              164,228
                                                                              
                                                                              
                                                                              
                                                                              2.60
                                                                              %
                                                                              
                                                                              
                                                                              2,116
                                                                              
                                                                              
                                                                              
                                                                              142,125
                                                                              
                                                                              
                                                                              
                                                                              3.62
                                                                              %
                                                                              
                                                                              
                                                                              2,561Brokered
      money market funds
                                                                              
                                                                              
                                                                              36,854
                                                                              
                                                                              
                                                                              
                                                                              0.72
                                                                              %
                                                                              
                                                                              
                                                                              131
                                                                              
                                                                              
                                                                              
                                                                              -
                                                                              
                                                                              
                                                                              
                                                                              0.00
                                                                              %
                                                                              
                                                                              
                                                                              -Brokered
      time deposits
                                                                              
                                                                              
                                                                              33,169
                                                                              
                                                                              
                                                                              
                                                                              1.74
                                                                              %
                                                                              
                                                                              
                                                                              287
                                                                              
                                                                              
                                                                              
                                                                              11,209
                                                                              
                                                                              
                                                                              
                                                                              3.91
                                                                              %
                                                                              
                                                                              
                                                                              218Total
      interest bearing deposits
                                                                              
                                                                              
                                                                              495,423
                                                                              
                                                                              
                                                                              
                                                                              1.65
                                                                              %
                                                                              
                                                                              
                                                                              4,059
                                                                              
                                                                              
                                                                              
                                                                              453,142
                                                                              
                                                                              
                                                                              
                                                                              2.35
                                                                              %
                                                                              
                                                                              
                                                                              5,305Federal
      funds purchased
                                                                              
                                                                              
                                                                              378
                                                                              
                                                                              
                                                                              
                                                                              1.07
                                                                              %
                                                                              
                                                                              
                                                                              2
                                                                              
                                                                              
                                                                              
                                                                              3,824
                                                                              
                                                                              
                                                                              
                                                                              2.94
                                                                              %
                                                                              
                                                                              
                                                                              56Securities
      sold under agreement to repurchase
                                                                              
                                                                              
                                                                              1,312
                                                                              
                                                                              
                                                                              
                                                                              0.31
                                                                              %
                                                                              
                                                                              
                                                                              2
                                                                              
                                                                              
                                                                              
                                                                              2,080
                                                                              
                                                                              
                                                                              
                                                                              2.61
                                                                              %
                                                                              
                                                                              
                                                                              27Federal
      Home Loan Bank borrowing
                                                                              
                                                                              
                                                                              89,105
                                                                              
                                                                              
                                                                              
                                                                              0.88
                                                                              %
                                                                              
                                                                              
                                                                              388
                                                                              
                                                                              
                                                                              
                                                                              67,170
                                                                              
                                                                              
                                                                              
                                                                              2.67
                                                                              %
                                                                              
                                                                              
                                                                              891Junior
      subordinated debentures
                                                                              
                                                                              
                                                                              13,403
                                                                              
                                                                              
                                                                              
                                                                              4.59
                                                                              %
                                                                              
                                                                              
                                                                              305
                                                                              
                                                                              
                                                                              
                                                                              13,403
                                                                              
                                                                              
                                                                              
                                                                              6.05
                                                                              %
                                                                              
                                                                              
                                                                              403Total
      borrowed funds
                                                                              
                                                                              
                                                                              104,198
                                                                              
                                                                              
                                                                              
                                                                              1.35
                                                                              %
                                                                              
                                                                              
                                                                              697
                                                                              
                                                                              
                                                                              
                                                                              86,477
                                                                              
                                                                              
                                                                              
                                                                              3.20
                                                                              %
                                                                              
                                                                              
                                                                              1,377Total
      interest bearing liabilities
                                                                              
                                                                              
                                                                              599,621
                                                                              
                                                                              
                                                                              
                                                                              1.60
                                                                              %
                                                                              
                                                                              
                                                                              4,756
                                                                              
                                                                              
                                                                              
                                                                              539,619
                                                                              
                                                                              
                                                                              
                                                                              2.49
                                                                              %
                                                                              
                                                                              
                                                                              6,682Non
      interest bearing demand
                                                                              
                                                                              
                                                                              154,971
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              148,518Total
      funding
                                                                              
                                                                              
                                                                              754,592
                                                                              
                                                                              
                                                                              
                                                                              1.27
                                                                              %
                                                                              
                                                                              
                                                                              4,756
                                                                              
                                                                              
                                                                              
                                                                              688,137
                                                                              
                                                                              
                                                                              
                                                                              1.95
                                                                              %
                                                                              
                                                                              
                                                                              6,682Other
      liabilities
                                                                              
                                                                              
                                                                              8,733
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              8,051Total
      liabilities
                                                                              
                                                                              $
                                                                              763,325
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              $
                                                                              696,188Stockholders'
      Equity:Preferred
      stock
                                                                              
                                                                              $
                                                                              10,921
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              $
                                                                              -Common
      stock
                                                                              
                                                                              
                                                                              48,661
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              45,164Additional
      paid in capital
                                                                              
                                                                              
                                                                              2,190
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              768Retained
      earnings
                                                                              
                                                                              
                                                                              23,162
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              25,416Valuation
      allowance investments
                                                                              
                                                                              
                                                                              (1,623
                                                                              )
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              78Total
      stockholders' equity
                                                                              
                                                                              
                                                                              83,311
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              71,426Total
      liabilities and stockholders' equity
                                                                              
                                                                              $
                                                                              846,636
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              $
                                                                              767,614Net
      interest income
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              $
                                                                              19,409
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              $
                                                                              18,709Net
      interest margin (3)
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              4.97
                                                                              %
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              
                                                                              5.31
                                                                              %





(1)
            Nonaccrual
      loans have been included in total loans.


(2)
            Loan
      fees of $483 and $724 for the six months ending June 30, 2009 and 2008,
      respectively have been included in interest income computation.


(3)
            Net
      interest margin has been calculated by dividing the net interest income by
      total average earning assets.


(4)
            Yield
      / Rate is annualized using actual number of days in period.




- 35
-




Management’s
Discussion and Analysis




The table
below sets forth changes in average interest earning assets and their respective
yields for the three and six month periods ending June 30, 2009 compared to the
same period ended in 2008:





Average
      Balance
                          
                          
                          
                          
                          
                          
                          
                          
                          Average
      Yieldfor
      the three months ending
                          
                          
                          
                          
                          
                          
                          
                          
                          for
      the three months endingJune
      30,
                          
                          
                          Variance
                          
                          
                          June
      30,(dollars
      in thousands)
                          
                          2009
                          
                          
                          2008
                          
                          
                          dollar
                          
                          
                          percentage
                          
                          
                          2009
                          
                          
                          2008
                          
                          
                          VarianceTime
      deposits with other banks
                          
                          $
                          119
                          
                          
                          $
                          281
                          
                          
                          $
                          (162
                          )
                          
                          
                          -57.65
                          %
                          
                          
                          3.37
                          %
                          
                          
                          4.29
                          %
                          
                          
                          -0.92
                          %Federal
      funds sold
                          
                          
                          20,816
                          
                          
                          
                          9,249
                          
                          
                          
                          11,567
                          
                          
                          
                          125.06
                          %
                          
                          
                          0.19
                          %
                          
                          
                          1.96
                          %
                          
                          
                          -1.77
                          %Investment
      securities taxable
                          
                          
                          57,746
                          
                          
                          
                          46,594
                          
                          
                          
                          11,152
                          
                          
                          
                          23.93
                          %
                          
                          
                          4.40
                          %
                          
                          
                          5.26
                          %
                          
                          
                          -0.86
                          %Investment
      securities non-taxable
                          
                          
                          19,412
                          
                          
                          
                          17,423
                          
                          
                          
                          1,989
                          
                          
                          
                          11.42
                          %
                          
                          
                          4.30
                          %
                          
                          
                          4.27
                          %
                          
                          
                          0.03
                          %Loans
      (1) (2)
                          
                          
                          705,779
                          
                          
                          
                          656,917
                          
                          
                          
                          48,862
                          
                          
                          
                          7.44
                          %
                          
                          
                          6.49
                          %
                          
                          
                          7.18
                          %
                          
                          
                          -0.69
                          %Total
      interest earning assets
                          
                          $
                          803,872
                          
                          
                          $
                          730,464
                          
                          
                          $
                          73,408
                          
                          
                          
                          10.05
                          %
                          
                          
                          6.12
                          %
                          
                          
                          6.92
                          %
                          
                          
                          -0.80
                          %





(1)
            Nonaccrual
      loans have been included in total loans.


(2)
            Loan
      fees of $225 and $369 for the three months ending June 30, 2009 and 2008,
      respectively have been included in the interest income
      computation.





Average
      Balance
                          
                          
                          
                          
                          
                          
                          
                          
                          Average
      Yieldfor
      the six months ending
                          
                          
                          
                          
                          
                          
                          
                          
                          for
      the six months endingJune
      30,
                          
                          
                          Variance
                          
                          
                          June
      30,(dollars
      in thousands)
                          
                          2009
                          
                          
                          2008
                          
                          
                          dollar
                          
                          
                          percentage
                          
                          
                          2009
                          
                          
                          2008
                          
                          
                          VarianceTime
      deposits with other banks
                          
                          $
                          119
                          
                          
                          $
                          306
                          
                          
                          $
                          (187
                          )
                          
                          
                          -61.11
                          %
                          
                          
                          3.39
                          %
                          
                          
                          3.94
                          %
                          
                          
                          -0.55
                          %Federal
      funds sold
                          
                          
                          16,852
                          
                          
                          
                          8,631
                          
                          
                          
                          8,221
                          
                          
                          
                          95.25
                          %
                          
                          
                          0.20
                          %
                          
                          
                          2.61
                          %
                          
                          
                          -2.41
                          %Investment
      securities taxable
                          
                          
                          51,507
                          
                          
                          
                          42,370
                          
                          
                          
                          9,137
                          
                          
                          
                          21.56
                          %
                          
                          
                          4.66
                          %
                          
                          
                          5.13
                          %
                          
                          
                          -0.47
                          %Investment
      securities non-taxable
                          
                          
                          18,293
                          
                          
                          
                          17,273
                          
                          
                          
                          1,020
                          
                          
                          
                          5.91
                          %
                          
                          
                          4.34
                          %
                          
                          
                          4.30
                          %
                          
                          
                          0.04
                          %Loans
      (1) (2)
                          
                          
                          700,804
                          
                          
                          
                          640,449
                          
                          
                          
                          60,355
                          
                          
                          
                          9.42
                          %
                          
                          
                          6.49
                          %
                          
                          
                          7.48
                          %
                          
                          
                          -0.99
                          %Total
      interest earning assets
                          
                          $
                          787,575
                          
                          
                          $
                          709,029
                          
                          
                          $
                          78,546
                          
                          
                          
                          11.08
                          %
                          
                          
                          6.19
                          %
                          
                          
                          7.20
                          %
                          
                          
                          -1.01
                          %





(1)
            Nonaccrual
      loans have been included in total loans.


(2)
            Loan
      fees of $483 and $724 for the six months ending June 30, 2009 and 2008,
      respectively have been included in the interest income
      computation.





At June
30, 2009, average interest earning assets were approximately $73.4 million and
$78.5 million higher than that reported over the same three and six month
periods ended a year earlier.  Organic loan growth as well as higher
balances of federal funds sold and investment securities are the primary factors
behind the increase.





For the
three and six month periods ended June 30, 2009, the average yield on loans was
6.49% and 6.49%, respectively.  This represents declines of 69 and 99
basis points from the 7.18% and 7.48% reported for the same periods ended a year
earlier.  As economic conditions worsened throughout 2008, the FOMC
moved to cut the overnight Fed Funds rate by over 400 basis points, which had a
direct impact on yields in the loan portfolio.  The decline in the
yield of the loan portfolio is the primary factor contributing to the year over
year decline in the yield on earning assets.  Additionally, higher
average balances of federal funds sold, resulting from substantial deposit
growth during the first half of 2009, placed further pressure on the yield on
earning assets.  For the three and six month periods ended June 30,
2009, the yield on earning assets declined approximately 80 and 101 basis points
when compared to the same periods ended a year ago.





Year over
year increases in the average balance of taxable investment securities can be
attributable to purchases the Bank made in a mix of collateralized mortgage
obligations from government sponsored agencies and private
issuers.


- 36
-




Management’s
Discussion and Analysis




The
tables below set forth changes in average interest bearing liabilities and their
respective rates for the three and six month periods ending June 30, 2009
compared to the same periods ended in 2008:





Average
      Balance
                      
                      
                      
                      
                      
                      
                      
                      
                      Average
      Ratefor
      the three months ending
                      
                      
                      
                      
                      
                      
                      
                      
                      for
      the three months endingJune
      30,
                      
                      
                      Variance
                      
                      
                      June
      30,(dollars
      in thousands)
                      
                      2009
                      
                      
                      2008
                      
                      
                      dollar
                      
                      
                      percentage
                      
                      
                      2009
                      
                      
                      2008
                      
                      
                      VarianceInterest
      bearing demand
                      
                      $
                      61,084
                      
                      
                      $
                      83,754
                      
                      
                      $
                      (22,670
                      )
                      
                      
                      -27.07
                      %
                      
                      
                      0.69
                      %
                      
                      
                      0.78
                      %
                      
                      
                      -0.09
                      %Savings
                      
                      
                      23,819
                      
                      
                      
                      24,343
                      
                      
                      
                      (524
                      )
                      
                      
                      -2.15
                      %
                      
                      
                      0.19
                      %
                      
                      
                      0.59
                      %
                      
                      
                      -0.40
                      %Money
      market
                      
                      
                      177,585
                      
                      
                      
                      187,616
                      
                      
                      
                      (10,031
                      )
                      
                      
                      -5.35
                      %
                      
                      
                      1.48
                      %
                      
                      
                      1.76
                      %
                      
                      
                      -0.28
                      %Time
      deposits
                      
                      
                      185,078
                      
                      
                      
                      136,709
                      
                      
                      
                      48,369
                      
                      
                      
                      35.38
                      %
                      
                      
                      2.52
                      %
                      
                      
                      3.14
                      %
                      
                      
                      -0.62
                      %Brokered
      money market funds
                      
                      
                      32,893
                      
                      
                      
                      -
                      
                      
                      
                      32,893
                      
                      
                      
                      100.00
                      %
                      
                      
                      0.82
                      %
                      
                      
                      0.00
                      %
                      
                      
                      0.82
                      %Brokered
      time deposits
                      
                      
                      36,907
                      
                      
                      
                      15,919
                      
                      
                      
                      20,988
                      
                      
                      
                      131.84
                      %
                      
                      
                      1.46
                      %
                      
                      
                      3.28
                      %
                      
                      
                      -1.82
                      %Federal
      funds purchased
                      
                      
                      109
                      
                      
                      
                      3,439
                      
                      
                      
                      (3,330
                      )
                      
                      
                      -96.83
                      %
                      
                      
                      1.10
                      %
                      
                      
                      2.46
                      %
                      
                      
                      -1.36
                      %Securities
      sold under repurchase agreements
                      
                      
                      -
                      
                      
                      
                      2,094
                      
                      
                      
                      (2,094
                      )
                      
                      
                      -100.00
                      %
                      
                      
                      0.00
                      %
                      
                      
                      1.92
                      %
                      
                      
                      -1.92
                      %Federal
      Home Loan Bank borrowing
                      
                      
                      68,956
                      
                      
                      
                      90,731
                      
                      
                      
                      (21,775
                      )
                      
                      
                      -24.00
                      %
                      
                      
                      0.83
                      %
                      
                      
                      2.46
                      %
                      
                      
                      -1.63
                      %Junior
      subordinated debentures
                      
                      
                      13,403
                      
                      
                      
                      13,403
                      
                      
                      
                      -
                      
                      
                      
                      0.00
                      %
                      
                      
                      4.49
                      %
                      
                      
                      5.40
                      %
                      
                      
                      -0.91
                      %Total
      interest bearing liabilities
                      
                      $
                      599,834
                      
                      
                      $
                      558,008
                      
                      
                      $
                      41,826
                      
                      
                      
                      7.50
                      %
                      
                      
                      1.62
                      %
                      
                      
                      2.15
                      %
                      
                      
                      -0.53
                      %




Average
      Balance
                      
                      
                      
                      
                      
                      
                      
                      
                      Average
      Ratefor
      the six months ending
                      
                      
                      
                      
                      
                      
                      
                      
                      for
      the six months endingJune
      30,
                      
                      
                      Variance
                      
                      
                      June
      30,(dollars
      in thousands)
                      
                      2009
                      
                      
                      2008
                      
                      
                      dollar
                      
                      
                      percentage
                      
                      
                      2009
                      
                      
                      2008
                      
                      
                      VarianceInterest
      bearing demand
                      
                      $
                      62,845
                      
                      
                      $
                      75,314
                      
                      
                      $
                      (12,469
                      )
                      
                      
                      -16.56
                      %
                      
                      
                      0.61
                      %
                      
                      
                      0.68
                      %
                      
                      
                      -0.07
                      %Savings
                      
                      
                      22,949
                      
                      
                      
                      28,634
                      
                      
                      
                      (5,685
                      )
                      
                      
                      -19.85
                      %
                      
                      
                      0.18
                      %
                      
                      
                      1.17
                      %
                      
                      
                      -0.99
                      %Money
      market
                      
                      
                      175,378
                      
                      
                      
                      195,860
                      
                      
                      
                      (20,482
                      )
                      
                      
                      -10.46
                      %
                      
                      
                      1.51
                      %
                      
                      
                      2.16
                      %
                      
                      
                      -0.65
                      %Time
      deposits
                      
                      
                      164,228
                      
                      
                      
                      142,125
                      
                      
                      
                      22,103
                      
                      
                      
                      15.55
                      %
                      
                      
                      2.60
                      %
                      
                      
                      3.62
                      %
                      
                      
                      -1.02
                      %Brokered
      money market funds
                      
                      
                      36,854
                      
                      
                      
                      -
                      
                      
                      
                      36,854
                      
                      
                      
                      100.00
                      %
                      
                      
                      0.72
                      %
                      
                      
                      0.00
                      %
                      
                      
                      0.72
                      %Brokered
      time deposits
                      
                      
                      33,169
                      
                      
                      
                      11,209
                      
                      
                      
                      21,960
                      
                      
                      
                      195.91
                      %
                      
                      
                      1.74
                      %
                      
                      
                      3.91
                      %
                      
                      
                      -2.17
                      %Federal
      funds purchased
                      
                      
                      378
                      
                      
                      
                      3,824
                      
                      
                      
                      (3,446
                      )
                      
                      
                      -90.12
                      %
                      
                      
                      1.07
                      %
                      
                      
                      2.94
                      %
                      
                      
                      -1.87
                      %Securities
      sold under repurchase agreements
                      
                      
                      1,312
                      
                      
                      
                      2,080
                      
                      
                      
                      (768
                      )
                      
                      
                      -36.92
                      %
                      
                      
                      0.31
                      %
                      
                      
                      2.61
                      %
                      
                      
                      -2.30
                      %Federal
      Home Loan Bank borrowing
                      
                      
                      89,105
                      
                      
                      
                      67,170
                      
                      
                      
                      21,935
                      
                      
                      
                      32.66
                      %
                      
                      
                      0.88
                      %
                      
                      
                      2.67
                      %
                      
                      
                      -1.79
                      %Junior
      subordinated debentures
                      
                      
                      13,403
                      
                      
                      
                      13,403
                      
                      
                      
                      -
                      
                      
                      
                      0.00
                      %
                      
                      
                      4.59
                      %
                      
                      
                      6.05
                      %
                      
                      
                      -1.46
                      %Total
      interest bearing liabilities
                      
                      $
                      599,621
                      
                      
                      $
                      539,619
                      
                      
                      $
                      60,002
                      
                      
                      
                      11.12
                      %
                      
                      
                      1.60
                      %
                      
                      
                      2.49
                      %
                      
                      
                      -0.89
                      %




At June
30, 2009, the balance of interest bearing liabilities was approximately $41.8
million and $60.0 million higher than that reported over the same three and six
month periods ended a year earlier.  During the majority of 2008 and
into the first six months of 2009, the Bank experienced continued strong loan
demand.  Meeting this demand with appropriately priced funding proved
to be challenging, resulting in higher year over year average balances from
alternative funding sources.  This is evidenced in the table above,
with increases in, brokered time deposits and additional money market deposits
obtained from the Reserve.  As conditions in the financial services
industry worsened dramatically throughout 2008, many financial institutions in
severe need of liquidity engaged in irrational deposit pricing, making it
difficult for the Bank to attract and retain core
deposits.  Management chose not to engage in this type of pricing and
instead pursued other inexpensive sources of funding to meet the demands of
borrowers and mitigate any substantial year over year decline in the net
interest margin.  However, as deposit pricing began to normalize
during 2009, the Bank was able to attract additional core deposits. The Bank
attributes deposit growth to several factors including work in making its two
bank brands top of mind in both of the Bank’s primary markets.  Growth
can also be attributed to the continued focus on providing excellent customer
service provided by the Bank’s staff.  Marketing and promotional
activities have also been beneficial in increasing core deposit balances as the
Bank has seen a flight to quality from some of the larger institutions in our
marketplace.  These events have proved to be successful, especially
within the second quarter of 2009, as the Bank was able to significantly
increase demand deposit, time certificate and money market balances to further
pay down FHLB borrowings and begin to reduce its reliance on brokered
funds.





Additionally,
the Bank stayed relatively short with respect to its interest bearing
liabilities during 2008 and into the first quarter of 2009.  This
proved to be beneficial with respect to the cost of its interest bearing
liabilities as the Federal Reserve moved aggressively to lower the overnight Fed
Funds rate by over 400 basis during 2008.  The Bank’s ability to
rapidly re-price a significant portion of its interest bearing liabilities in a
declining rates environment helped to keep funding costs relatively low and
reduce the impact of falling rates on the net interest margin.




- 37
-




Management’s
Discussion and Analysis




The
volume and rate variances table below sets forth the dollar difference in
interest earned and paid for each major category of interest-earning assets and
interest-bearing liabilities for the three and six month periods ended June 30,
2009 over the same period ended in 2008, and the amount of such change
attributable to changes in average balances (volume) or changes in average
yields and rates:





For
      the three months ended
                          
                          
                          For
      the six months endedJune
      30, 2009 over 2008
                          
                          
                          June
      30, 2009 over 2008(dollars
      in thousands)
                          
                          Volume
                          
                          
                          Rate
                          
                          
                          Total
                          
                          
                          Volume
                          
                          
                          Rate
                          
                          
                          TotalInterest
      Income:Investments
      with other banks
                          
                          $
                          (1
                          )
                          
                          $
                          (1
                          )
                          
                          $
                          (2
                          )
                          
                          $
                          (4
                          )
                          
                          $
                          -
                          
                          
                          $
                          (4
                          )Federal
      funds sold
                          
                          
                          (125
                          )
                          
                          
                          90
                          
                          
                          
                          (35
                          )
                          
                          
                          (3,357
                          )
                          
                          
                          3,262
                          
                          
                          
                          (95
                          )Investment
      securities taxable
                          
                          
                          78
                          
                          
                          
                          (53
                          )
                          
                          
                          25
                          
                          
                          
                          190
                          
                          
                          
                          (82
                          )
                          
                          
                          108Investment
      securities non-taxable (2)
                          
                          
                          33
                          
                          
                          
                          2
                          
                          
                          
                          35
                          
                          
                          
                          32
                          
                          
                          
                          6
                          
                          
                          
                          38Taxable
      equivalent adjustment (2)
                          
                          
                          (11
                          )
                          
                          
                          (1
                          )
                          
                          
                          (12
                          )
                          
                          
                          (11
                          )
                          
                          
                          (2
                          )
                          
                          
                          (13
                          )Loans
      (1)
                          
                          
                          1,068
                          
                          
                          
                          (1,384
                          )
                          
                          
                          (316
                          )
                          
                          
                          3,145
                          
                          
                          
                          (4,405
                          )
                          
                          
                          (1,260
                          )Net
      increase (decrease)
                          
                          
                          1,042
                          
                          
                          
                          (1,347
                          )
                          
                          
                          (305
                          )
                          
                          
                          (5
                          )
                          
                          
                          (1,221
                          )
                          
                          
                          (1,226
                          )Interest
      Expense:Savings,
      NOW, money market
                          
                          
                          (81
                          )
                          
                          
                          (167
                          )
                          
                          
                          (248
                          )
                          
                          
                          (272
                          )
                          
                          
                          (729
                          )
                          
                          
                          (1,001
                          )Time
      deposits
                          
                          
                          212
                          
                          
                          
                          (119
                          )
                          
                          
                          93
                          
                          
                          
                          542
                          
                          
                          
                          (987
                          )
                          
                          
                          (445
                          )Brokered
      funds
                          
                          
                          5
                          
                          
                          
                          65
                          
                          
                          
                          70
                          
                          
                          
                          96
                          
                          
                          
                          104
                          
                          
                          
                          200Other
      borrowings
                          
                          
                          (128
                          )
                          
                          
                          (315
                          )
                          
                          
                          (443
                          )
                          
                          
                          439
                          
                          
                          
                          (1,021
                          )
                          
                          
                          (582
                          )Long
      term debt
                          
                          
                          -
                          
                          
                          
                          (30
                          )
                          
                          
                          (30
                          )
                          
                          
                          -
                          
                          
                          
                          (98
                          )
                          
                          
                          (98
                          )Net
      increase (decrease)
                          
                          
                          8
                          
                          
                          
                          (566
                          )
                          
                          
                          (558
                          )
                          
                          
                          805
                          
                          
                          
                          (2,731
                          )
                          
                          
                          (1,926
                          )Total
      net increase (decrease)
                          
                          $
                          1,034
                          
                          
                          $
                          (781
                          )
                          
                          $
                          253
                          
                          
                          $
                          (810
                          )
                          
                          $
                          1,510
                          
                          
                          $
                          700





(1)
            Loan
      fees of $225 and $369 for the three months ending June 30, 2009 and 2008
      and $483 and $724 for the six months ending June 30, 2009 and 2008,
      respectively.


(2)
            Adjusted
      to a fully taxable equivalent basis using a tax rate of 34%.





Non-Interest
Income





The table
below sets forth changes in non-interest income for the three and six month
periods ended June 30, 2009 compared to the same periods ended in
2008:





For
      the three months endedJune
      30,
                          
                          
                          Variance(dollars
      in thousands)
                          
                          2009
                          
                          
                          2008
                          
                          
                          dollar
                          
                          
                          percentageService
      charges on deposit accounts
                          
                          $
                          752
                          
                          
                          $
                          837
                          
                          
                          $
                          (85
                          )
                          
                          
                          -10.16
                          %ATM/Debit
      and credit card transaction/interchange fees
                          
                          
                          254
                          
                          
                          
                          232
                          
                          
                          
                          22
                          
                          
                          
                          9.48
                          %Bancard
                          
                          
                          55
                          
                          
                          
                          70
                          
                          
                          
                          (15
                          )
                          
                          
                          -21.43
                          %Mortgage
      origination fees
                          
                          
                          336
                          
                          
                          
                          83
                          
                          
                          
                          253
                          
                          
                          
                          304.82
                          %Earnings
      on bank owned life insurance
                          
                          
                          124
                          
                          
                          
                          119
                          
                          
                          
                          5
                          
                          
                          
                          4.20
                          %Other
      commissions and fees
                          
                          
                          83
                          
                          
                          
                          378
                          
                          
                          
                          (295
                          )
                          
                          
                          -78.04
                          %Gain
      on sale of investment securities
                          
                          
                          -
                          
                          
                          
                          37
                          
                          
                          
                          (37
                          )
                          
                          
                          -100.00
                          %Loss
      on sale of OREO
                          
                          
                          (104
                          )
                          
                          
                          -
                          
                          
                          
                          (104
                          )
                          
                          
                          100.00
                          %Total
      non interest income
                          
                          $
                          1,500
                          
                          
                          $
                          1,756
                          
                          
                          $
                          (256
                          )
                          
                          
                          -14.58
                          %




- 38
-




Management’s
Discussion and Analysis


For
      the six months endedJune
      30,
                        
                        
                        Variance(dollars
      in thousands)
                        
                        2009
                        
                        
                        2008
                        
                        
                        dollar
                        
                        
                        percentageService
      charges on deposit accounts
                        
                        $
                        1,464
                        
                        
                        $
                        1,609
                        
                        
                        $
                        (145
                        )
                        
                        
                        -9.01
                        %ATM/Debit
      and credit card transaction/interchange fees
                        
                        
                        470
                        
                        
                        
                        440
                        
                        
                        
                        30
                        
                        
                        
                        6.82
                        %Bancard
                        
                        
                        92
                        
                        
                        
                        113
                        
                        
                        
                        (21
                        )
                        
                        
                        -18.58
                        %Mortgage
      origination fees
                        
                        
                        665
                        
                        
                        
                        249
                        
                        
                        
                        416
                        
                        
                        
                        167.07
                        %Earnings
      on bank owned life insurance
                        
                        
                        246
                        
                        
                        
                        231
                        
                        
                        
                        15
                        
                        
                        
                        6.49
                        %Other
      commissions and fees
                        
                        
                        232
                        
                        
                        
                        516
                        
                        
                        
                        (284
                        )
                        
                        
                        -55.04
                        %Gain
      on sale of investment securities
                        
                        
                        122
                        
                        
                        
                        37
                        
                        
                        
                        85
                        
                        
                        
                        229.73
                        %Loss
      on sale of OREO
                        
                        
                        (131
                        )
                        
                        
                        -
                        
                        
                        
                        (131
                        )
                        
                        
                        100.00
                        %Total
      non interest income
                        
                        $
                        3,160
                        
                        
                        $
                        3,195
                        
                        
                        $
                        (35
                        )
                        
                        
                        -1.10
                        %








Non-interest
income for the three and six months ended June 30, 2009 decreased approximately
$256 thousand or 14.58% and $35 thousand or 1.10%, respectively when compared to
the same periods ended in 2008.  Contributing substantially to the
year over year declines is the absence of income the Bank recognized in the
approximate amount of $272 thousand during the second quarter of 2008 in
connection with the Visa, Inc. IPO.  Additionally, losses recognized
on the sale of OREO properties during the second quarter of 2009 contributed
further to the year over year declines in interest income.





Gains
recognized from the sale of five investment securities during the first quarter
of 2009 in the approximate amount of $122 thousand helped to offset the year to
date decline in non-interest income.





Further
offsetting the declines in non-interest income was the substantial year over
year increase in mortgage origination fee income.  Income within this
category increased approximately $253 thousand or 304.82% and $416 thousand or
167.07% when compared to the same periods ended a year earlier.  The
Bank witnessed a significant increase in the number of home loan re-financings
during the first six months of 2009 when compared to the same period ended a
year earlier as a result of a significantly lower rate environment.





As the
result of a significant reduction in the number of competitors in mortgage
origination within the Bank’s market, the Bank recognized the opportunity to
expand the mortgage origination department. The Bank hired a well seasoned
mortgage manager who has been able to expand the Bank’s penetration into the
origination market both in San Luis Obispo and Santa Barbara counties. This
strategy has performed well at this point as is exhibited by the revenue
generation of the department.





The table
below illustrates the change in the number and total dollar volume of mortgage
loans originated during the three and six months ended June 30, 2009 when
compared to the same period ended in 2008:





For
      the three months ended June 30,(dollars
      in thousands)
                  
                  2009
                  
                  
                  2008
                  
                  
                  VarianceDollar
      volume
                  
                  $
                  46,622
                  
                  
                  $
                  12,973
                  
                  
                  
                  259.4
                  %Number
      of loans
                  
                  
                  149
                  
                  
                  
                  38
                  
                  
                  
                  292.1
                  %





For
      the six months ended June 30,(dollars
      in thousands)
                  
                  2009
                  
                  
                  2008
                  
                  
                  VarianceDollar
      volume
                  
                  $
                  88,687
                  
                  
                  $
                  29,377
                  
                  
                  
                  201.9
                  %Number
      of loans
                  
                  
                  278
                  
                  
                  
                  83
                  
                  
                  
                  234.9
                  %




- 39
-




Management’s
Discussion and Analysis




Non-Interest
Expenses





The table
below sets forth changes in non-interest expenses for the three and six month
periods ended June 30, 2009 compared to the same periods ended in
2008:





For
      the three months endedJune
      30,
                        
                        
                        Variance(dollars
      in thousands)
                        
                        2009
                        
                        
                        2008
                        
                        
                        dollar
                        
                        
                        percentageSalaries
      and employee benefits
                        
                        $
                        3,745
                        
                        
                        $
                        4,021
                        
                        
                        $
                        (276
                        )
                        
                        
                        -6.86
                        %Occupancy
                        
                        
                        826
                        
                        
                        
                        778
                        
                        
                        
                        48
                        
                        
                        
                        6.17
                        %Equipment
                        
                        
                        376
                        
                        
                        
                        351
                        
                        
                        
                        25
                        
                        
                        
                        7.12
                        %Promotional
                        
                        
                        225
                        
                        
                        
                        235
                        
                        
                        
                        (10
                        )
                        
                        
                        -4.26
                        %Data
      processing
                        
                        
                        691
                        
                        
                        
                        672
                        
                        
                        
                        19
                        
                        
                        
                        2.83
                        %Stationery
      and supplies
                        
                        
                        99
                        
                        
                        
                        105
                        
                        
                        
                        (6
                        )
                        
                        
                        -5.71
                        %Regulatory
      fees
                        
                        
                        537
                        
                        
                        
                        117
                        
                        
                        
                        420
                        
                        
                        
                        358.97
                        %Audit
      and tax costs
                        
                        
                        147
                        
                        
                        
                        114
                        
                        
                        
                        33
                        
                        
                        
                        28.95
                        %Amortization
      of core deposit intangible
                        
                        
                        262
                        
                        
                        
                        215
                        
                        
                        
                        47
                        
                        
                        
                        21.86
                        %Director
      fees
                        
                        
                        80
                        
                        
                        
                        80
                        
                        
                        
                        -
                        
                        
                        
                        0.00
                        %Communications
                        
                        
                        61
                        
                        
                        
                        79
                        
                        
                        
                        (18
                        )
                        
                        
                        -22.78
                        %Other
                        
                        
                        965
                        
                        
                        
                        731
                        
                        
                        
                        234
                        
                        
                        
                        32.01
                        %Total
      non interest expense
                        
                        $
                        8,014
                        
                        
                        $
                        7,498
                        
                        
                        $
                        516
                        
                        
                        
                        6.88
                        %




For
      the six months endedJune
      30,
                        
                        
                        Variance(dollars
      in thousands)
                        
                        2009
                        
                        
                        2008
                        
                        
                        dollar
                        
                        
                        percentageSalaries
      and employee benefits
                        
                        $
                        7,548
                        
                        
                        $
                        8,247
                        
                        
                        $
                        (699
                        )
                        
                        
                        -8.48
                        %Occupancy
                        
                        
                        1,678
                        
                        
                        
                        1,551
                        
                        
                        
                        127
                        
                        
                        
                        8.19
                        %Equipment
                        
                        
                        701
                        
                        
                        
                        717
                        
                        
                        
                        (16
                        )
                        
                        
                        -2.23
                        %Promotional
                        
                        
                        326
                        
                        
                        
                        481
                        
                        
                        
                        (155
                        )
                        
                        
                        -32.22
                        %Data
      processing
                        
                        
                        1,361
                        
                        
                        
                        1,326
                        
                        
                        
                        35
                        
                        
                        
                        2.64
                        %Stationery
      and supplies
                        
                        
                        203
                        
                        
                        
                        224
                        
                        
                        
                        (21
                        )
                        
                        
                        -9.38
                        %Regulatory
      fees
                        
                        
                        680
                        
                        
                        
                        225
                        
                        
                        
                        455
                        
                        
                        
                        202.22
                        %Audit
      and tax costs
                        
                        
                        295
                        
                        
                        
                        228
                        
                        
                        
                        67
                        
                        
                        
                        29.39
                        %Amortization
      of core deposit intangible
                        
                        
                        525
                        
                        
                        
                        430
                        
                        
                        
                        95
                        
                        
                        
                        22.09
                        %Director
      fees
                        
                        
                        163
                        
                        
                        
                        158
                        
                        
                        
                        5
                        
                        
                        
                        3.16
                        %Communications
                        
                        
                        123
                        
                        
                        
                        152
                        
                        
                        
                        (29
                        )
                        
                        
                        -19.08
                        %Other
                        
                        
                        1,836
                        
                        
                        
                        1,379
                        
                        
                        
                        457
                        
                        
                        
                        33.14
                        %Total
      non-interest expense
                        
                        $
                        15,439
                        
                        
                        $
                        15,118
                        
                        
                        $
                        321
                        
                        
                        
                        2.12
                        %





Salary
and Employee Benefits





Salaries
and employee related expenses declined approximately $276 thousand and $699
thousand for the three and six month periods ended June 30, 2009 when compared
to the same periods ended a year earlier.  Efficiencies the Bank
gained with respect to staffing during the later part of 2008 and into 2009
contributed to the majority of the year over year decline within this
category.




Occupancy
Expenses





Year over
year increases within this category are primarily attributable to annual
increases in rental expense.




Promotion
Expenses





Year over
year declines within this category are primarily attributable to cost cutting
measures Management implemented during the first quarter of
2009.


- 40
-




Management’s
Discussion and Analysis




Regulatory
Fees





For the
three and six months ended June 30, 2009, regulatory fees were approximately
$420 thousand and $455 thousand higher than that reported for the same periods
ended a year earlier.  During the second quarter of 2009 the Bank took
a one time charge in the approximate amount of $388 thousand related to a
special assessment imposed by the FDIC on all lending institutions with the
intent to replenish the Deposit Insurance Fund. Regular quarterly assessment
fees imposed by the FDIC have also increased from year ago levels and may
increase further throughout 2009.





Core
Deposit Intangible (“CDI”) Amortization





Upon the
acquisition of Business First the Company booked CDI in the approximate amount
of $3.8 million.  The balance of this intangible will be amortized
over a six year period pursuant to a schedule provided in the initial valuation
process.  For the three and six months ended June 30, 2009 CDI
amortization was approximately $47 thousand and $95 thousand higher than that
reported for the same periods ended in 2008 of which substantially all can be
attributed to the Business First acquisition.





Other
Expenses





Expenses
within this category increased approximately $234 thousand and $457 thousand
during the three and six months ended June 30, 2009 when compared to the same
periods ended a year ago.  The majority of the increase within this
category can be attributed to expenses incurred related to the acquisition,
write-down and maintenance of foreclosed collateral in the approximate amounts
of $193 thousand and $337 thousand for the three and six month periods ended
June 30, 2009, respectively.





Year over
year increases within this category can also be attributed to increased loan
department costs related to strong mortgage origination volume as well as
expenses incurred related to collection efforts.  Loan department
costs increased approximately $58 thousand and $105 thousand during the three
and six month periods ended June 30, 2009 when compared to the same periods
ended a year ago.





Management
continues to utilize various cost cutting measures in an effort to mitigate the
declines seen in net income, resulting in large part from the elevated
provisions made to the allowance for loan losses and declines in yields on
earning assets. As evidenced in the tables and discussion above, non-interest
expenses have declined or remained relatively unchanged in a number of
categories, exclusive of one time items such as the special assessment imposed
by the FDIC and various OREO related expenses.  Exclusive of these one
time items, non-interest expenses for the three and six month periods ended June
30, 2009 would have declined approximately $65 thousand and $404 thousand,
respectively.





Provision
for Income Taxes





For the
three and six month periods ended June 30, 2009 the provision for income taxes
was 19.3% and 30.6% of pre tax income compared to 35.5% and 37.3% for the same
periods ended a year earlier.  The primary reason behind the year over
year decline in the Company’s effective tax rate when compared to the same
periods ended a year earlier is attributable to substantial increases in the
provision for loan losses and the permanent difference associated with tax
exempt interest income the Company earned on municipal securities and income
from holdings of bank owned life insurance becoming a larger percentage of
overall taxable income.





Provision
for Loan Losses





An
allowance for loan losses has been established by Management to provide for
those loans that may not be repaid in their entirety for a variety of
reasons.  The allowance is maintained at a level considered by
Management to be adequate to provide for probable incurred
losses.  The allowance for loan losses is comprised of three
components: specific credit allocation, general portfolio allocation, and
subjectively determined allocation.  The allowance is increased by
provisions charged to earnings and is reduced by charge-offs, net of
recoveries.  The provision for loan losses is based upon past loan
loss experience and Management’s evaluation of the loan portfolio under current
economic conditions.  Loans are charged to the allowance for loan
losses when, and to the extent, they are deemed by Management to be
un-collectible.


- 41
-


Management’s
Discussion and Analysis


The Bank
recognizes that credit losses will be experienced and the risk of loss will vary
with, among other things, general economic conditions; the type of loan being
made; the creditworthiness of the borrower over the term of the loan and in the
case of a collateralized loan, the quality of the collateral for such
loan.  The allowance for loan losses represents the Bank’s estimate of
the allowance necessary to provide for probable incurred losses in the portfolio
as of the balance sheet date.  In making this determination, the Bank
analyzes the ultimate collectibility of the loans in the portfolio by
incorporating feedback provided by internal loan staff, an independent loan
review function, and information provided by examinations performed by
regulatory agencies.  The Bank makes monthly evaluations as to the
adequacy of the allowance for loan losses.





The Bank
accounts for problem loans in accordance with SFAS No.114,“Accounting by Creditors for
Impairment of a Loan,” as amended by SFAS No. 118, “Accounting by Creditors for
Impairment of a Loan - Income Recognition and
Disclosures.”  These pronouncements provide that when it is
probable that a creditor will be unable to collect all amounts due in accordance
with the terms of the loan that such loan is deemed
impaired.  Impaired loans are accounted for differently in that the
amount of the impairment is measured and reflected in the records of the
creditor.  The allowance for credit losses related to loans that are
identified for evaluation in accordance with SFAS No. 114 is based on discounted
cash flows using the loan’s initial effective interest rate or the fair value of
the collateral for certain collateral dependent loans.  The general
portfolio allocation of the allowance consists of an assigned reserve percentage
based on the credit rating of the loan.  The subjective portion is
determined based on loan history and the Bank’s evaluation of various factors
including current economic conditions and trends in the portfolio including
delinquencies and impairment, as well as changes in the composition of the
portfolio.





The
allowance for loan losses is based on estimates, and ultimate losses will vary
from current estimates.  These estimates are reviewed monthly by the
Bank’s Directors, Loan Committee and full Board of Directors, and as
adjustments, either positive or negative, become necessary, a corresponding
increase or decrease is made in the provision for loan losses.  The
methodology used to determine the adequacy of the allowance for loan losses for
the three and six months ended June 30, 2009 is consistent with prior
periods.





The
Bank’s provision for loan losses was $2.7 million and $4.8 million for the three
and six month periods ended June 30, 2009 compared to provisions of $2.8 million
and $3.0 million for the same periods ended a year
earlier.  Provisions made to the allowance for loan losses during the
first six months of 2009, were approximately $1.8 million higher than that
reported for the same period a year earlier.  As economic conditions
throughout 2008 and 2009 worsened on national, state and local levels, the Bank
moved to increase the allowance as required by monthly analyses the Bank
conducts in determining its adequacy to cover potential losses in the loan
portfolio.  The Bank employs the use of a “watch list” and loan
grading system to assist in monitoring the quality of certain credits in the
loan portfolio.  As loans on the watch list and any other loan within
the portfolio experience deterioration, the Bank typically moves to downgrade
such loans, resulting in an increase in the required allowance to cover any
potential losses.  Management believes the significant economic
downturn witnessed during 2008 and that has continued into 2009 has had a
considerable impact on the ability of certain borrowers to satisfy their
obligations to the Bank, resulting in watch list expansion, loan downgrades and
corresponding increases in loan loss provisions.  Additionally, the
Bank makes estimates as to the impact that certain economic factors will have on
various credits within the portfolio.  Negative economic trends
witnessed during 2008 have continued thus far into 2009 and contributed
substantially to increases in the required allowance to cover potential losses
in the loan portfolio, resulting in year over year increases in loan loss
provisions.





Losses in
the commercial and industrial, construction and land segments of the loan
portfolio during the first six months of 2009 compared to the same period a year
earlier increased significantly, contributing to the additional provisions the
Bank made to the allowance for loan losses.  Although the majority of
losses within these segments of the portfolio were the result of several large
write-downs, the Bank has witnessed an increase in the number and total dollar
volume of past due loans within the commercial and industrial, construction and
land segments.  Additionally, while the Bank saw a decline in the
balance of non-accruing loans when compared to that reported a year ago,
non-accruing balances remain elevated relative to historical periods, also
contributing to increased loan loss provisions.  Continued increases
in the level of charge-offs and the number and dollar volume of past due and
non-performing loans may result in further provisions to the allowance for loan
losses.





Looking
forward into 2009, Management anticipates there to be further weakness in
economic conditions on national, state and local levels.  Many
economic forecasts suggest further increases in the national unemployment rate,
which will undoubtedly place continued pressure on conditions within the Bank’s
primary market area.  Continued economic pressures may negatively
impact the financial condition of borrowers to whom the Bank has extended credit
and as a result the Bank may be required to make further significant provisions
to the allowance for loan losses during 2009.  That said, Management
has been and will continue to be proactive in looking for signs of deterioration
within the loan portfolio in an effort to manage credit quality and work with
borrowers where possible to mitigate any further losses.





As of
June 30, 2009, Management believes, based on all current and available
information, the allowance for loan losses is adequate to absorb current
estimable losses within the loan portfolio.




- 42
-




Management’s
Discussion and Analysis




Financial
Condition





At June
30, 2009, total assets were $881.4 million.  This when compared to the
$805.6 million reported at December 31, 2008, represents an increase of
approximately $75.8 million or 9.4%.  Increases in investment
securities, federal funds sold, and the net balance of the loan portfolio were
primary factors behind the year to date increase in total assets.  An
increase of $26.0 million in the balance of federal funds sold are attributable
in part to the dramatic increases we saw in deposit balances during the first
six months of 2009.  Net increases in the investment portfolio of
approximately $25.0 million are the result of purchases the Bank made during
2009 to take advantage of increased credit spreads on investment
securities.  During the first six months of 2009, the loan portfolio
grew approximately $17.2 million, contributing to overall growth in total
assets.





At June
30, 2009, total deposits were approximately $704.0 million or approximately
$100.5 million higher than the $603.5 million reported at December 31,
2008.  Increases in non-interest bearing demand and retail time
deposits contributed to the year to date increase in
deposits.  Deposit growth during the first six months of 2009 allowed
the Bank to pay down brokered funds as well as borrowings with the
FHLB.  Net of the pay down in brokered funds, total deposits grew
approximately $110.6 million from that reported at December 31,
2008.  During the first six month of 2009, FHLB borrowings declined
$44.0 million.  See also “Deposits and Borrowed Funds” of this
discussion and analysis for additional information related to the changes in
deposit balances and wholesale borrowings.





Loans





At June
30, 2009 total gross loan balances were $697.8 million.  This
represents an increase of approximately $17.7 million or 2.6% from the $680.1
million reported at December 31, 2008.  Higher real estate secured and
commercial loan balances contributed to the majority of the year to date
increase in the portfolio.





The
following table provides a summary of year to date variances in the loan
portfolio as of June 30, 2009:





June
      30,
                              
                              
                              December
      31,
                              
                              
                              Variance(dollars
      in thousands)
                              
                              2009
                              
                              
                              2008
                              
                              
                              dollar
                              
                              
                              percentageReal
      Estate SecuredMulti-family
      residential
                              
                              $
                              17,414
                              
                              
                              $
                              16,206
                              
                              
                              $
                              1,208
                              
                              
                              
                              7.45
                              %Residential
      1 to 4 family
                              
                              
                              23,626
                              
                              
                              
                              23,910
                              
                              
                              
                              (284
                              )
                              
                              
                              -1.19
                              %Home
      equity line of credit
                              
                              
                              29,049
                              
                              
                              
                              26,409
                              
                              
                              
                              2,640
                              
                              
                              
                              10.00
                              %Commercial
                              
                              
                              302,735
                              
                              
                              
                              285,631
                              
                              
                              
                              17,104
                              
                              
                              
                              5.99
                              %Farmland
                              
                              
                              9,639
                              
                              
                              
                              10,723
                              
                              
                              
                              (1,084
                              )
                              
                              
                              -10.11
                              %CommercialCommercial
      and industrial
                              
                              
                              171,208
                              
                              
                              
                              157,674
                              
                              
                              
                              13,534
                              
                              
                              
                              8.58
                              %Agriculture
                              
                              
                              14,231
                              
                              
                              
                              13,744
                              
                              
                              
                              487
                              
                              
                              
                              3.54
                              %Other
                              
                              
                              491
                              
                              
                              
                              620
                              
                              
                              
                              (129
                              )
                              
                              
                              -20.81
                              %ConstructionSingle
      family residential
                              
                              
                              14,710
                              
                              
                              
                              11,414
                              
                              
                              
                              3,296
                              
                              
                              
                              28.88
                              %Single
      family residential - Spec.
                              
                              
                              10,338
                              
                              
                              
                              15,395
                              
                              
                              
                              (5,057
                              )
                              
                              
                              -32.85
                              %Tract
                              
                              
                              3,202
                              
                              
                              
                              2,431
                              
                              
                              
                              771
                              
                              
                              
                              31.72
                              %Multi-family
                              
                              
                              5,648
                              
                              
                              
                              5,808
                              
                              
                              
                              (160
                              )
                              
                              
                              -2.75
                              %Hospitality
                              
                              
                              12,388
                              
                              
                              
                              18,630
                              
                              
                              
                              (6,242
                              )
                              
                              
                              -33.51
                              %Commercial
                              
                              
                              17,215
                              
                              
                              
                              21,484
                              
                              
                              
                              (4,269
                              )
                              
                              
                              -19.87
                              %Land
                              
                              
                              57,149
                              
                              
                              
                              61,681
                              
                              
                              
                              (4,532
                              )
                              
                              
                              -7.35
                              %Installment
      loans to individuals
                              
                              
                              8,428
                              
                              
                              
                              7,851
                              
                              
                              
                              577
                              
                              
                              
                              7.35
                              %All
      other loans (including overdrafts)
                              
                              
                              383
                              
                              
                              
                              536
                              
                              
                              
                              (153
                              )
                              
                              
                              -28.54
                              %Total
      loans, gross
                              
                              
                              697,854
                              
                              
                              
                              680,147
                              
                              
                              
                              17,707
                              
                              
                              
                              2.60
                              %Deferred
      loan fees
                              
                              
                              1,555
                              
                              
                              
                              1,701
                              
                              
                              
                              (146
                              )
                              
                              
                              -8.58
                              %Reserve
      for possible loan losses
                              
                              
                              11,106
                              
                              
                              
                              10,412
                              
                              
                              
                              694
                              
                              
                              
                              6.67
                              %Total
      loans, net
                              
                              $
                              685,193
                              
                              
                              $
                              668,034
                              
                              
                              $
                              17,159
                              
                              
                              
                              2.57
                              %Loans
      held for sale
                              
                              $
                              11,692
                              
                              
                              $
                              7,939
                              
                              
                              $
                              3,753
                              
                              
                              
                              47.27
                              %




- 43
-




Management’s
Discussion and Analysis




Real
Estate Secured





The
following table provides a break-down of the real estate secured segment of the
Bank’s loan portfolio as of June 30, 2009:





June
      30, 2009
                      
                      
                      
                      
                      
                      Percent
      of
                      
                      
                      
                      
                      
                      SingleUndisbursed
                      
                      
                      Total
      Bank
                      
                      
                      Percent
                      
                      
                      Bank's
      Risk
                      
                      
                      Number
                      
                      
                      Largest(dollars
      in thousands)
                      
                      Balance
                      
                      
                      Commitment
                      
                      
                      Exposure
                      
                      
                      Composition
                      
                      
                      Based
      Capital
                      
                      
                      of
      Loans
                      
                      
                      LoanRetail
                      
                      $
                      45,270
                      
                      
                      $
                      3,528
                      
                      
                      $
                      48,798
                      
                      
                      
                      11.9
                      %
                      
                      
                      50.5
                      %
                      
                      
                      67
                      
                      
                      $
                      5,000Professional
                      
                      
                      70,208
                      
                      
                      
                      864
                      
                      
                      
                      71,072
                      
                      
                      
                      17.3
                      %
                      
                      
                      73.6
                      %
                      
                      
                      101
                      
                      
                      
                      8,875Hospitality
                      
                      
                      70,540
                      
                      
                      
                      120
                      
                      
                      
                      70,660
                      
                      
                      
                      17.2
                      %
                      
                      
                      73.2
                      %
                      
                      
                      41
                      
                      
                      
                      10,891Multi-family
                      
                      
                      17,414
                      
                      
                      
                      -
                      
                      
                      
                      17,414
                      
                      
                      
                      4.2
                      %
                      
                      
                      18.0
                      %
                      
                      
                      19
                      
                      
                      
                      4,131Home
      equity lines of credit
                      
                      
                      29,049
                      
                      
                      
                      20,629
                      
                      
                      
                      49,678
                      
                      
                      
                      12.1
                      %
                      
                      
                      51.5
                      %
                      
                      
                      308
                      
                      
                      
                      1,250Residential
      1 to 4 family
                      
                      
                      23,626
                      
                      
                      
                      615
                      
                      
                      
                      24,241
                      
                      
                      
                      5.9
                      %
                      
                      
                      25.1
                      %
                      
                      
                      65
                      
                      
                      
                      3,000Farmland
                      
                      
                      9,639
                      
                      
                      
                      1,465
                      
                      
                      
                      11,104
                      
                      
                      
                      2.7
                      %
                      
                      
                      11.5
                      %
                      
                      
                      23
                      
                      
                      
                      1,937Healthcare
      / medical
                      
                      
                      16,005
                      
                      
                      
                      -
                      
                      
                      
                      16,005
                      
                      
                      
                      3.9
                      %
                      
                      
                      16.6
                      %
                      
                      
                      29
                      
                      
                      
                      2,155Restaurants
      / food establishments
                      
                      
                      7,173
                      
                      
                      
                      -
                      
                      
                      
                      7,173
                      
                      
                      
                      1.7
                      %
                      
                      
                      7.4
                      %
                      
                      
                      13
                      
                      
                      
                      2,541Commercial
                      
                      
                      76,198
                      
                      
                      
                      1,396
                      
                      
                      
                      77,594
                      
                      
                      
                      18.9
                      %
                      
                      
                      80.4
                      %
                      
                      
                      108
                      
                      
                      
                      4,714Other
                      
                      
                      17,341
                      
                      
                      
                      71
                      
                      
                      
                      17,412
                      
                      
                      
                      4.2
                      %
                      
                      
                      18.0
                      %
                      
                      
                      32
                      
                      
                      
                      2,100Total
      real estate secured
                      
                      $
                      382,463
                      
                      
                      $
                      28,688
                      
                      
                      $
                      411,151
                      
                      
                      
                      100.0
                      %
                      
                      
                      425.8
                      %
                      
                      
                      806
                      
                      
                      $
                      46,594





As of
June 30, 2009, real estate secured balances represented approximately $382.5
million of total gross loans.  This when compared to the $362.9
million reported at December 31, 2008, represents an increase of approximately
$19.6 million or 5.4%.  The primary factor behind the year to date
increase can be attributed to higher commercial real estate
balances.  Year to date increases within this category can be
attributed to the completion of several large construction projects and their
subsequent reclassification from construction to commercial real
estate.  The aggregate balance of these large loans was approximately
$14.9 million at June 30, 2009.  During the first six months of the
year the Bank also made several new loans in excess of $1.0
million.  The aggregate balance of these loans was approximately $7.3
million as of June 30, 2009.  These new loans were made to borrowers
in the industries of commercial and hospitality.  The Bank also had
several large payoffs and pay downs in excess of $0.5 million during the first
six months of the year, totaling approximately $3.7 million.





Loans
classified as multi-family residential also contributed to the year to date
increase within the real estate secured portfolio.  Contributing
substantially to the year to date increase was the funding of one loan in the
aggregate amount of $2.3 million.  This loan was made to a non profit
organization within the Bank’s primary market.  Notable pay downs
within this category include the pay down of one loan in the aggregate amount of
$1.4 million.





HELOC
disbursements also contributed to the year to date increase within the real
estate secured portfolio, rising approximately $2.6 million from the $26.4
million reported at December 31, 2008.





At June
30, 2009, real estate secured commitments represented approximately 425.8% of
the Bank’s total risk based capital.  This when compared to the 510.7%
reported at December 31, 2008, represents a decline of 84.9 percentage
points.  The additional capital obtained under the U.S. Treasury’s CPP
is the primary factor behind the year to date decline.  While the real
estate secured portfolio in aggregate represents a concentration, no single
category within this segment of the portfolio is considered a concentration as
of June 30, 2009.





At June
30, 2009, approximately $160.2 million or 41.9% of the real estate secured
segment of the loan portfolio was considered owner occupied.





Capitalization
rates, the rate at which a stream of cash flows are discounted to find their
present value, on commercial properties in our primary market area for the last
three years were as follows: 5.0% to 6.5% in 2006, 6.0% to 7.0% in 2007, and
4.5% to 8.0% in 2008.  A recent uptick in capitalization rates would
indicate that we are seeing some pressure on commercial real estate prices
within our market, primarily resulting from weakened economic
conditions.





In
September 2004, the Bank issued an $11.7 million irrevocable standby letter of
credit to guarantee the payment of taxable variable rate demand bonds that has
since been reduced to $11.4 million.  The primary purpose of the bond
issue was to refinance existing debt and provide funds for capital improvement
and expansion of an assisted living facility.  The project is 100%
complete and fully leased.  The letter of credit was renewed in July
2009 and will expire in September 2010.


- 44
-




Management’s
Discussion and Analysis




Commercial





The
following table provides a break-down of the commercial and industrial segment
of the Bank’s commercial loan portfolio as of June 30, 2009:





June
      30, 2009
                        
                        
                        
                        
                        
                        Percent
      of
                        
                        
                        
                        
                        
                        SingleUndisbursed
                        
                        
                        Total
      Bank
                        
                        
                        Percent
                        
                        
                        Bank's
      Risk
                        
                        
                        Number
                        
                        
                        Largest(dollars
      in thousands)
                        
                        Balance
                        
                        
                        Commitment
                        
                        
                        Exposure
                        
                        
                        Composition
                        
                        
                        Based
      Capital
                        
                        
                        of
      Loans
                        
                        
                        LoanAgriculture
                        
                        $
                        3,827
                        
                        
                        $
                        2,732
                        
                        
                        $
                        6,559
                        
                        
                        
                        2.5
                        %
                        
                        
                        6.8
                        %
                        
                        
                        29
                        
                        
                        $
                        2,000Oil,
      gas and utilities
                        
                        
                        2,129
                        
                        
                        
                        1,133
                        
                        
                        
                        3,262
                        
                        
                        
                        1.3
                        %
                        
                        
                        3.4
                        %
                        
                        
                        12
                        
                        
                        
                        1,200Construction
                        
                        
                        19,751
                        
                        
                        
                        15,138
                        
                        
                        
                        34,889
                        
                        
                        
                        13.4
                        %
                        
                        
                        36.1
                        %
                        
                        
                        173
                        
                        
                        
                        2,750Manufacturing
                        
                        
                        11,218
                        
                        
                        
                        9,989
                        
                        
                        
                        21,207
                        
                        
                        
                        8.2
                        %
                        
                        
                        22.0
                        %
                        
                        
                        111
                        
                        
                        
                        2,100Wholesale
      and retail
                        
                        
                        16,379
                        
                        
                        
                        6,453
                        
                        
                        
                        22,832
                        
                        
                        
                        8.8
                        %
                        
                        
                        23.6
                        %
                        
                        
                        126
                        
                        
                        
                        1,250Transportation
      and warehousing
                        
                        
                        2,796
                        
                        
                        
                        659
                        
                        
                        
                        3,455
                        
                        
                        
                        1.3
                        %
                        
                        
                        3.6
                        %
                        
                        
                        35
                        
                        
                        
                        596Media
      and information services
                        
                        
                        10,702
                        
                        
                        
                        2,191
                        
                        
                        
                        12,893
                        
                        
                        
                        5.0
                        %
                        
                        
                        13.4
                        %
                        
                        
                        27
                        
                        
                        
                        8,000Financial
      services
                        
                        
                        17,931
                        
                        
                        
                        7,483
                        
                        
                        
                        25,414
                        
                        
                        
                        9.8
                        %
                        
                        
                        26.3
                        %
                        
                        
                        51
                        
                        
                        
                        6,000Real
      estate / rental and leasing
                        
                        
                        16,985
                        
                        
                        
                        10,430
                        
                        
                        
                        27,415
                        
                        
                        
                        10.5
                        %
                        
                        
                        28.4
                        %
                        
                        
                        95
                        
                        
                        
                        3,500Professional
      services
                        
                        
                        18,350
                        
                        
                        
                        8,657
                        
                        
                        
                        27,007
                        
                        
                        
                        10.4
                        %
                        
                        
                        28.0
                        %
                        
                        
                        144
                        
                        
                        
                        2,000Healthcare
      / medical & social services
                        
                        
                        19,976
                        
                        
                        
                        19,758
                        
                        
                        
                        39,734
                        
                        
                        
                        15.3
                        %
                        
                        
                        41.2
                        %
                        
                        
                        120
                        
                        
                        
                        11,355Restaurants
      and hospitality
                        
                        
                        23,024
                        
                        
                        
                        3,291
                        
                        
                        
                        26,315
                        
                        
                        
                        10.1
                        %
                        
                        
                        27.3
                        %
                        
                        
                        113
                        
                        
                        
                        6,000All
      other
                        
                        
                        8,140
                        
                        
                        
                        757
                        
                        
                        
                        8,897
                        
                        
                        
                        3.4
                        %
                        
                        
                        9.2
                        %
                        
                        
                        60
                        
                        
                        
                        2,062Total
      commercial and industrial
                        
                        $
                        171,208
                        
                        
                        $
                        88,671
                        
                        
                        $
                        259,879
                        
                        
                        
                        100.0
                        %
                        
                        
                        269.3
                        %
                        
                        
                        1,096
                        
                        
                        $
                        48,813




At June
30, 2009, commercial loans represented approximately $185.9 million of total
gross loan balances.  This when compared to the $172.0 million
reported at December 31, 2008, represents an increase of approximately $13.9
million or 8.1%.  Increases in the commercial and industrial category
were the primary factor behind the year to date increase.





During
the first six months of the year the Bank made several new loans as well as
notable disbursements in amounts in excess of $1.0 million, totaling
approximately $9.5 million.  These new loans and disbursements were
made to borrowers in the following industries: healthcare / medical, wholesale
and retail, real estate / rental and leasing, oil / gas and utilities, and
construction.





Although
the commercial and industrial category as a whole does represent a concentration
at 269.3% of the Bank’s total risk based capital, there was no one particular
industry to which the Bank has extended credit within the commercial and
industrial category that represented a concentration as of June 30,
2009.  At June 30, 2009, commercial and industrial commitments as a
percent of the Bank’s total risk based capital were approximately 269.3% or 54.7
percentage points lower than the 324.0% reported at December 31,
2008.  The additional capital obtained under the U.S. Treasury’s CPP
is the primary factor behind the year to date decline.





Construction





The
following table provides a break-down of the construction segment of the Bank’s
loan portfolio as of June 30, 2009:





June
      30, 2009
                      
                      
                      
                      
                      
                      Percent
      of
                      
                      
                      
                      
                      
                      SingleUndisbursed
                      
                      
                      Total
      Bank
                      
                      
                      Percent
                      
                      
                      Bank's
      Risk
                      
                      
                      Number
                      
                      
                      Largest(dollars
      in thousands)
                      
                      Balance
                      
                      
                      Commitment
                      
                      
                      Exposure
                      
                      
                      Composition
                      
                      
                      Based
      Capital
                      
                      
                      of
      Loans
                      
                      
                      LoanSingle
      family residential
                      
                      $
                      14,710
                      
                      
                      $
                      6,139
                      
                      
                      $
                      20,849
                      
                      
                      
                      23.9
                      %
                      
                      
                      21.6
                      %
                      
                      
                      24
                      
                      
                      $
                      4,600Single
      family residential - Spec.
                      
                      
                      10,338
                      
                      
                      
                      725
                      
                      
                      
                      11,063
                      
                      
                      
                      12.7
                      %
                      
                      
                      11.5
                      %
                      
                      
                      9
                      
                      
                      
                      3,480Tract
                      
                      
                      3,202
                      
                      
                      
                      188
                      
                      
                      
                      3,390
                      
                      
                      
                      3.9
                      %
                      
                      
                      3.5
                      %
                      
                      
                      15
                      
                      
                      
                      532Multi-family
                      
                      
                      5,648
                      
                      
                      
                      1,611
                      
                      
                      
                      7,259
                      
                      
                      
                      8.3
                      %
                      
                      
                      7.5
                      %
                      
                      
                      5
                      
                      
                      
                      3,584Commercial
                      
                      
                      17,215
                      
                      
                      
                      13,255
                      
                      
                      
                      30,470
                      
                      
                      
                      34.9
                      %
                      
                      
                      31.6
                      %
                      
                      
                      24
                      
                      
                      
                      6,100Hospitality
                      
                      
                      12,388
                      
                      
                      
                      1,928
                      
                      
                      
                      14,316
                      
                      
                      
                      16.3
                      %
                      
                      
                      14.8
                      %
                      
                      
                      3
                      
                      
                      
                      7,359Total
      construction
                      
                      $
                      63,501
                      
                      
                      $
                      23,846
                      
                      
                      $
                      87,347
                      
                      
                      
                      100.0
                      %
                      
                      
                      90.5
                      %
                      
                      
                      80
                      
                      
                      $
                      25,655




At June
30, 2009, construction balances represented approximately $63.5 million or 9.1%
of total gross loan balances.  This when compared to the $75.2 million
reported at December 31, 2008, represents a decline of approximately $11.7
million or 15.6%.


- 45
-





Management’s
Discussion and Analysis





As
previously stated the primary factor behind the year to date decline can be
attributed to construction loans moving into amortizing loans under the
commercial real estate category as well as a general decline in demand for loans
of this type in the current economic environment.





Year to
date declines in the category of single family residential – spec can be
attributed in large part to the charge off of several loans and their subsequent
movement into OREO status, totaling approximately $6.0 million.





Declines
in the categories of commercial and hospitality are attributable in large part
to balances moving to commercial real estate upon completion of underlying
projects as well as pay downs.





At June
30, 2009 total construction commitments represented approximately 90.5% of the
Bank’s total risk based capital.  This when compared to the 135.9%
reported at December 31, 2008, represents a decline of approximately 45.4
percentage points.  The additional capital obtained under the
Company’s participation in the U.S. Treasury’s CPP contributed substantially to
the year to date decline.  Approximately $25.1 million or 39.5% of the
Bank’s construction portfolio was considered owner occupied as of June 30,
2009.





Construction
loans are typically granted for a one year period and then, with income
properties, are amortized over a period not more than 30 years with 10 to 15
year maturities.





Land





The
following table provides a break-down of the land segment of the Bank’s loan
portfolio as of June 30, 2009:





June 30, 2009
                    
                    
                    
                    
                    
                    Percent of
                    
                    
                    
                    
                    
                    SingleUndisbursed
                    
                    
                    Total Bank
                    
                    
                    Percent
                    
                    
                    Bank's Risk
                    
                    
                    Number
                    
                    
                    Largest(dollars in thousands)
                    
                    Balance
                    
                    
                    Commitment
                    
                    
                    Exposure
                    
                    
                    Composition
                    
                    
                    Based Capital
                    
                    
                    of Loans
                    
                    
                    LoanSingle family residential
                    
                    $
                    8,201
                    
                    
                    $
                    92
                    
                    
                    $
                    8,293
                    
                    
                    
                    13.8
                    %
                    
                    
                    8.6
                    %
                    
                    
                    26
                    
                    
                    $
                    1,200Single
      family residential - Spec.
                    
                    
                    2,067
                    
                    
                    
                    -
                    
                    
                    
                    2,067
                    
                    
                    
                    3.4
                    %
                    
                    
                    2.1
                    %
                    
                    
                    8
                    
                    
                    
                    618Tract
                    
                    
                    30,495
                    
                    
                    
                    1,616
                    
                    
                    
                    32,111
                    
                    
                    
                    53.5
                    %
                    
                    
                    33.3
                    %
                    
                    
                    11
                    
                    
                    
                    12,208Multi-family
                    
                    
                    1,509
                    
                    
                    
                    3
                    
                    
                    
                    1,512
                    
                    
                    
                    2.5
                    %
                    
                    
                    1.6
                    %
                    
                    
                    3
                    
                    
                    
                    675Commercial
                    
                    
                    10,796
                    
                    
                    
                    1,119
                    
                    
                    
                    11,915
                    
                    
                    
                    19.9
                    %
                    
                    
                    12.3
                    %
                    
                    
                    21
                    
                    
                    
                    1,500Hospitality
                    
                    
                    4,081
                    
                    
                    
                    -
                    
                    
                    
                    4,081
                    
                    
                    
                    6.9
                    %
                    
                    
                    4.2
                    %
                    
                    
                    4
                    
                    
                    
                    2,340Total
      land
                    
                    $
                    57,149
                    
                    
                    $
                    2,830
                    
                    
                    $
                    59,979
                    
                    
                    
                    100.0
                    %
                    
                    
                    62.1
                    %
                    
                    
                    73
                    
                    
                    $
                    18,541





At June
30, 2009, land balances represented approximately $57.1 million or 8.2% of total
gross loan balances.  When compared to the $61.7 million reported at
December 31, 2008, land balances declined approximately $4.6
million.  The year to date decline can be attributed to the pay down /
payoff of several loans in the aggregate amount of $2.7
million.  Additionally, during the first six months of the year the
Bank charged off and subsequently moved to OREO approximately $3.3 million in
land balances, contributing to the year to date decline.





New loans
within this category include five loans to five borrowers in the aggregate
amount of $1.3 million.  The majority of these loans are classified as
land – commercial as of June 30, 2009 and were made to borrowers within the
Bank’s primary market area.





Two of
the largest existing loans within this category consist of loans for residential
tract developments in the aggregate amount of $11.8 million.  These
projects are located in Kern County of the California Central
Valley.  One project is approved for 314 single family
lots.  This project has also been approved for approximately 8.6 acres
of commercial development and 13.5 acres for recreational
purposes.  The project was funded in the first quarter of 2008 and had
an approximate loan to value of 50.0%, based on an appraisal conducted at the
time.  At June 30, 2009 the balance of this loan was approximately
$11.3 million, with approximately $0.9 million un-disbursed.  However,
given the current economic environment, the borrower intends to delay commercial
and residential development of the property and instead has begun to develop the
project site into a rock quarry operation, with limited competition for this
business in the borrower’s market.   The borrower has begun to
receive cash flows from these operations and it is anticipated that it will
provide significant cash flows in future periods to help pay down the
loan.  To that end, the Bank intends to order a new appraisal of the
property, including the quarry, during the third quarter of 2009 and require, if
necessary, the borrower to provide a principal reduction in order to maintain a
maximum LTV of 50.0% based on new appraisals.  Additionally, the Bank
anticipates this loan to be reclassified from land tract development to
commercial and industrial.


- 46
-




Management’s
Discussion and Analysis





The
purpose of the second project is to provide affordable housing to a market that
generally consists of renters and is the only new housing development in its
area.  This loan funded in March 2008 at approximately $4.1 million
and has subsequently been paid down by approximately $3.6 million from proceeds
of sold homes, with approximately $1.7 million in pay downs occurring during the
first six months of 2009.  The borrower is actively marketing the
remaining finished homes and sales continue to occur at a rate of one to two
homes per month.  Additionally, the housing in this project qualifies
for the USDA Direct Loan program whereby individuals or families receive
financial assistance directly from the Housing and Community Facilities Programs
(“HCFP”) in the form of a home loan at an affordable interest
rate.  As of June 30, 2009, these loans were performing under the
contractual terms of their respective loan agreements.





The Bank
does not typically make loans outside of its market footprint unless the
potential for a long term relationship, including the acquisition of additional
core deposits, exists.  Kern County, while contiguous to San Luis
Obispo County is somewhat outside of the Company’s market footprint, has a
population of approximately 800,000 and depends on agriculture, oil, light
industry, warehousing and distribution, and educational services to support its
economy.  This region of California’s Central Valley has experienced
significant population growth in recent years relative to other areas of the
state.  Affordable housing, compared to other metropolitan areas
within California, has been a significant factor behind the growth in Kern
County’s population.  However, like many other areas within
California, real estate prices within the California Central Valley have fallen
significantly, with recent indications showing year over year declines of 30% -
40% within Kern County, specifically.  Management acknowledges that as
economic conditions worsen across the state, the level of growth previously
experienced within the California Central Valley as well the purchasing power of
consumers within that market will no doubt be negatively impacted.  As
such, Management continues to carefully monitor loans made to borrowers in the
Central Valley for any sign of deterioration.





At June
30, 2009 total land commitments represented 62.1% of the Bank’s total risk based
capital.  When compared to the 85.2% reported at December 31, 2008,
this represents a decline of approximately 23.1 percentage
points.  The additional capital obtained under the Company’s
participation in the U.S. Treasury’s CPP contributed substantially to the year
to date decline.





At June
30, 2009 approximately $9.4 million or 16.5% of total land balances were
considered owner occupied.





Installment





At June
30, 2009, the installment loan balances were approximately $8.4
million.  This, when compared to the $7.9 million reported at December
31, 2008, represents an increase of approximately $0.5
million.  Installment loans include revolving credit plans, consumer
loans, as well as credit card balances obtained in the acquisition of Business
First.





Loans
Held for Sale





Loans
held for sale consist of mortgage originations that have already been sold
pursuant to correspondent mortgage loan agreements. There is no interest rate
risk associated with these loans as the commitments are in place at the time the
Bank funds them. Settlement from the correspondents is typically within 30 to 45
days.  At June 30, 2009 mortgage correspondent loans (loans held for
sale) totaled approximately $11.7 million.  This when compared to the
$7.9 million reported at December 31, 2008, represents an increase of
approximately $3.8 million.  The dramatic year over year decline in
interest rates has lead to significantly higher mortgage re-financing volumes,
which combined with the Bank's expansion
of its mortgage origination department to further the Bank's penetration its
market, have contributedsubstantially to the year to date
increase within this category.





Foreign
Loans





At June
30, 2009 the Bank had no foreign loans outstanding.





- 47
-


Management’s
Discussion and Analysis




Summary
of Market Condition


The
residential real estate market came under significant pressure during 2008 and
has shown no significant signs of improvement thus far in 2009.  The
market was negatively impacted by rising interest rates during the majority of
2007, negative sentiment surrounding market values of real estate, an over
supply of newly constructed homes and inflationary
pressures.  Additionally, as conditions in the credit markets worsened
during 2008, financial institutions became more reluctant to extend new credit
to borrowers, pushing the cost of certain types of credit higher in a rates down
environment and contributing further to the decline in real estate
prices.  As more and more home owners began to see interest rates
reset higher on adjustable rate mortgages late in 2007 and into 2008, the number
of delinquent and non-performing loans rose significantly in the industry as a
whole and have remained at elevated levels thus far in 2009.  During
the later part of 2008, the credit markets came under increasingly intense
pressure, specifically during the third and fourth quarters. This was fueled in
part by a widespread lack of confidence in the U.S. financial system, which led
many financial institutions to further tighten the extension of new credit given
concerns over the lack of liquidity, asset quality, and the conservation of
capital.  Also contributing significantly to the troubles seen in the
housing market and U.S. financial system have been a weakened economy and
consequently higher levels of unemployment, placing considerable pressure on the
U.S. consumer’s ability to satisfy their outstanding obligations to the
financial sector.  The Company believes these factors have placed
pressure on certain borrowers in the Bank’s market, contributing to the
increased level of non-performing assets the Bank experienced during 2008 and
thus far into 2009.





Prices of single family homes have
fallen significantly year over year in the Company's market area andCaliforniaas a whole, with recent indications
showing price declines in excess of 30% to 40% statewide and 29% to 34% within
the Company's market area.  Along with other segments in the real
estate sector, commercial real estate prices in the Company's market area
experienced some pressure during 2008 and the Company has begun to see increases
in vacancy rates in certain retail, industrial and office
segments.  The most recent data available to the Company shows vacancy
rates within retail, industrial and office segments to be approximately 3.0%,
5.4% and 6.1%, respectively as of the third quarter of 2008.  When
compared to levels in the year ago period, this represents respective increases
of approximately 160, 310 and 260 basis points.  The Company realizes
that any prolonged and significant downturn in the national and local economies
may further impact the values of commercial real estate within its market
footprint as well as the borrowers to whom the Bank has extended such
credit.  As such, Management continues to closely monitor the credits
within this segment of the loan portfolio for potential signs of
deterioration.  Additionally, the Bank is aware that as economic
conditions worsen and levels of unemployment continue to rise, borrowers to whom
the Bank has extended commercial lines of credit may come under additional
pressure to satisfy their outstanding obligations.  That said, the
Bank continues to employ stringent lending standards and remains very selective
with regard to any additional commercial real estate, real estate construction,
land and commercial loans it chooses to originate in an effort to effectively
manage risk in this difficult credit environment.


Although,
the Company’s market footprint has historically enjoyed a more stable level of
economic growth, we are not completely immune to the effects of a slowdown on a
state or national level.  As previously mentioned, with the effects of
a weakened economy placing more pressure on borrowers, the ability of consumers
to satisfy outstanding obligations to the financial sector, as a whole, has
begun to languish.  We believe that within certain areas of our local
economy these more macro level concerns have started to become more
evident.  This has no doubt had an impact on the level of and type of
loans the Bank has placed on non-accrual and charged-off during 2008 and into
2009.  Additionally, the Company has devoted considerable resources to
the monitoring of credits within the loan portfolio in order to take any
appropriate steps when and if necessary to mitigate any material adverse impact
the effects of weakened economic conditions may have on the Bank
overall.





As of
June 30, 2009, substantially all loans the Bank originated within the major
categories of commercial real estate, construction, land, and commercial and
industrial were made to borrowers within our current market
footprint.





Non-Performing
Assets





The
Bank’s Management is responsible for monitoring loan performance, which is done
through various methods, including a review of loan delinquencies and personal
knowledge of customers.  Additionally, the Bank maintains both a
“watch” list of loans that, for a variety of reasons, Management believes
require regular review as well as an internal loan classification
process.  Semi-annually, the loan portfolio is also reviewed by an
experienced, outside loan reviewer not affiliated with the Bank.  A
list of delinquencies, the watch list, internal loan classifications and the
outside loan review are reviewed regularly by the Bank’s Board of
Directors.





The Bank
has a non-accrual policy that requires a loan greater than 90 days past due
and/or is specifically determined to be impaired to be placed on non-accrual
status unless such loan is well-collateralized and in the process of
collection.  When loans are placed on non-accrual status, all accrued
but uncollected interest income is reversed from earnings.  Once on
non-accrual status payments received on such loans are applied as a reduction of
the loan principal balance.  Interest on a loan is only recognized on
a cash basis and is generally not recognized on specific impaired loans unless
the likelihood of further loss is remote.  Loans may be returned to
accrual status if Management believes that all remaining principal and interest
is fully collectible and there has been at least six months of sustained
repayment performance since the loan was placed on non-accrual.


- 48
-


Management’s
Discussion and Analysis


If a
loan’s credit quality deteriorates to the point that collection of principal is
believed by Management to be doubtful and the value of collateral securing the
obligation is sufficient the Bank generally takes steps to protect and liquidate
the collateral.  Any loss resulting from the difference between the
loan balance and the fair market value of the collateral is recognized by a
charge to the allowance for loan losses.  When collateral is held for
sale after foreclosure, it is subject to a periodic appraisal.  If the
appraisal indicates that the collateral will sell for less than its recorded
value, the Bank recognizes the loss by a charge to non-interest
expense.





Management
acknowledges that due to negative undertones associated with the economy and
real estate markets, the internal watch list has expanded over the last twelve
months.  While credit quality is consistently monitored, Management
has implemented additional precautionary actions that include but are not
limited to pro-actively identifying credit weaknesses earlier in the collection
cycle, increasing the oversight frequency of watch list credits and devoting
additional internal resources to monitor those credits.  Although the
Bank believes these actions will serve to potentially minimize any future losses
the Bank may incur related to problem loans, we cannot guarantee that the Bank
will not experience an increase in non-performing loans.





The
following table provides a summary of non-accruing loans as of June 30, 2009 and
December 31, 2008:





June 30,
                                    
                                    
                                    December 31,(dollars in thousands)
                                    
                                    2009
                                    
                                    
                                    2008Loans delinquent 90 days or more and still
      accruing
                                    
                                    $
                                    140
                                    
                                    
                                    $
                                    348Non-Accruing
      Loans:Commercial
      real estate
                                    
                                    $
                                    2,776
                                    
                                    
                                    
                                    1,961Residential
      1-4 family
                                    
                                    
                                    392
                                    
                                    
                                    
                                    265Home
      equity lines of credit
                                    
                                    
                                    320
                                    
                                    
                                    
                                    320Commercial
                                    
                                    
                                    5,316
                                    
                                    
                                    
                                    7,060Agriculture
                                    
                                    
                                    384
                                    
                                    
                                    
                                    -Construction
                                    
                                    
                                    2,267
                                    
                                    
                                    
                                    5,990Land
                                    
                                    
                                    511
                                    
                                    
                                    
                                    2,720Installment loans
                                    
                                    
                                    132
                                    
                                    
                                    
                                    11Total non-accruing loans
                                    
                                    $
                                    12,098
                                    
                                    
                                    $
                                    18,327Other real estate owned
                                    
                                    $
                                    6,669
                                    
                                    
                                    $
                                    1,337Total non-performing assets
                                    
                                    $
                                    18,907
                                    
                                    
                                    $
                                    20,012Ratio
      of allowance for credit losses to total gross loans
                                    
                                    
                                    1.59
                                    %
                                    
                                    
                                    1.53
                                    %Ratio
      of allowance for credit losses to total non-performing
    loans
                                    
                                    
                                    90.75
                                    %
                                    
                                    
                                    55.75
                                    %Ratio
      of non-performing loans to total gross loans
                                    
                                    
                                    1.75
                                    %
                                    
                                    
                                    2.75
                                    %Ratio
      of non-performing assets to total assets
                                    
                                    
                                    2.15
                                    %
                                    
                                    
                                    2.48
                                    %





At June
30, 2009 the balance of non-accruing loans was approximately $12.1 million or
$6.2 million lower than the $18.3 million reported at December 31,
2008.  Notable changes in the balance of non-accruing loans occurred
within the categories of commercial real estate, commercial and industrial,
construction and land.  Contributing substantially to the year to date
decline in non-accruing balances were pay downs the Bank received on
non-accruing loans of approximately $1.3 million, charge-offs of approximately
$4.1 million, and approximately $8.4 million in balances moving to OREO
status.  Additionally, the Bank returned two loans totaling
approximately $1.3 million to accruing status after working with the respective
borrowers.  Offsetting these factors was the addition of $8.8 million
in loans to non-accruing status during the first six months of
2009.





Non
performing assets totaled approximately $18.9 million at June 30, 2009,
approximately $1.1 million lower than that reported at December 31,
2008.  At June 30, 2009, the allowance for loan losses was
approximately $11.1 million or 1.59% of total gross loans.  When
compared to the $10.4 million or 1.53% reported at December 31, 2008, the
allowance increased approximately $0.7 million.  During the three and
six months ended June 30, 2009, the Bank made provisions to the allowance for
loan losses in the amounts of $2.7 million and $4.8 million,
respectively.  Net charge-offs for the three and six months ended June
30, 2009 totaled approximately $2.0 million and $4.1 million,
respectively.


- 49
-




Management’s
Discussion and Analysis





The
following table reconciles the change in non accruing balances for the six
months ended June 30, 2009:





Balance
                            
                            
                            Additions to
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            
                            Transfers
                            
                            
                            BalanceDecember 31,
                            
                            
                            Non-Accruing
                            
                            
                            Net
                            
                            
                            
                            
                            
                            Returns to
                            
                            
                            to OREO
                            
                            
                            June 30,(dollars in thousands)
                            
                            2008
                            
                            
                            Balances
                            
                            
                            Paydowns
                            
                            
                            Charge-offs
                            
                            
                            Accrual
                            
                            
                            Status
                            
                            
                            2009Real
      Estate SecuredMulti-family
      residential
                            
                            $
                            -
                            
                            
                            $
                            -
                            
                            
                            $
                            -
                            
                            
                            $
                            -
                            
                            
                            $
                            -
                            
                            
                            $
                            -
                            
                            
                            $
                            -Residential
      1 to 4 family
                            
                            
                            265
                            
                            
                            
                            146
                            
                            
                            
                            (19
                            )
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            392Home
      equity line of credit
                            
                            
                            320
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            320Commercial
                            
                            
                            1,961
                            
                            
                            
                            1,398
                            
                            
                            
                            (548
                            )
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            (35
                            )
                            
                            
                            2,776Farmland
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -CommercialCommercial
      and industrial
                            
                            
                            7,060
                            
                            
                            
                            1,584
                            
                            
                            
                            (347
                            )
                            
                            
                            (1,225
                            )
                            
                            
                            (14
                            )
                            
                            
                            (1,742
                            )
                            
                            
                            5,316Agriculture
                            
                            
                            -
                            
                            
                            
                            385
                            
                            
                            
                            (1
                            )
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            384Other
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -ConstructionSingle
      family residential
                            
                            
                            -
                            
                            
                            
                            823
                            
                            
                            
                            -
                            
                            
                            
                            (145
                            )
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            678Single
      family residential - Spec.
                            
                            
                            5,990
                            
                            
                            
                            2,839
                            
                            
                            
                            -
                            
                            
                            
                            (1,676
                            )
                            
                            
                            (1,250
                            )
                            
                            
                            (4,314
                            )
                            
                            
                            1,589Tract
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -Multi-family
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -Hospitality
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -Commercial
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -Land
                            
                            
                            2,720
                            
                            
                            
                            1,421
                            
                            
                            
                            (362
                            )
                            
                            
                            (991
                            )
                            
                            
                            -
                            
                            
                            
                            (2,277
                            )
                            
                            
                            511Installment
      loans to individuals
                            
                            
                            11
                            
                            
                            
                            224
                            
                            
                            
                            (2
                            )
                            
                            
                            (101
                            )
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            132All
      other loans
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            -Totals
                            
                            $
                            18,327
                            
                            
                            $
                            8,820
                            
                            
                            $
                            (1,279
                            )
                            
                            $
                            (4,138
                            )
                            
                            $
                            (1,264
                            )
                            
                            $
                            (8,368
                            )
                            
                            $
                            12,098





The
following table reconciles the change in balances classified as 90 days past due
and still accruing for the six months ended June 30, 2009:





Balance
                
                
                Additions to
                
                
                Transfers to
                
                
                
                
                
                Transfers
                
                
                BalanceDecember 31,
                
                
                90 Day Plus
                
                
                Non-Accruing
                
                
                
                
                
                to OREO
                
                
                June 30,(dollars in thousands)
                
                2008
                
                
                Balances
                
                
                Status
                
                
                Charge-offs
                
                
                Status
                
                
                2009Loans
      90 days deliquent or  more and still accruing
                
                $
                348
                
                
                $
                582
                
                
                $
                (790
                )
                
                $
                -
                
                
                $
                -
                
                
                $
                140





The
following provides additional information regarding non-accruing loans and OREO
balances as of June 30, 2009:





Real
Estate Secured Commercial





Comprising
a considerable portion of balances within this category are two loans to one
borrower in the aggregate amount of $1.1 million.  Both of these loans
are well secured and the Bank is working with the borrower to liquidate the
collateral and expects no loss to be incurred at this time.  During
the second quarter of 2009, the Bank received proceeds in the amount of $0.5
million from the sale of collateral securing one loan as well as approximately
$42 thousand in principal pay downs on two other credits, bringing the balance
of CRE non-accruing loans down slightly from that reported at March 31,
2009.  However, balances within this category increased approximately
$0.8 million when compared to that reported at December 31, 2008.





Commercial
and Industrial





During
the first six months of 2009, the Bank added approximately $1.6 million to
non-accruing status within the commercial and industrial segment.  Of
the $1.2 million in charge-offs occurring within this segment, approximately
$0.7 million can be attributed to three loans, while $0.4 million can be
attributed to several smaller loans added to non-accruing status during the
second quarter and subsequently charged-off.  The Bank also moved two
loans to one borrower in the aggregate amount of $1.7 million to OREO status
during the second quarter of 2009.  These loans are secured by
commercial property within the Bank’s primary market.  At June 30,
2009, the majority of balances on non-accrual within this segment consisted of
one loan to one borrower in the approximate amount of $3.6
million.  This loan is secured by property within the Bank’s primary
market.


- 50
-




Management’s
Discussion and Analysis





Construction
Single Family Residential





Balances
within this category consist of two loans to two borrowers.  The Bank
is currently working with the borrowers to liquidate the
collateral.  Collateral securing these loans is located in the Bank’s
primary market.





Single
Family Residential- Spec





At June
30, 2009 the balance of non-accruing loans within this category consisted of one
loan to one borrower and is secured by real estate in the Bank’s primary
market.  The Bank is currently working with the borrower to liquidate
the collateral.  Additions to this category during the first six
months of 2009 include the loan previously mentioned as well as another loan in
the amount of $1.3 million.  After working with the borrower, the loan
was brought current and subsequently returned to accruing status during the
second quarter of 2009.  During the first six month of 2009, the Bank
moved four loans to two borrowers to OREO status, totaling approximately $4.3
million.  During the second quarter of 2009 the Bank sold two of these
properties for $2.4 million as well as another single family residential – spec
property, previously booked to OREO, for approximately $0.5
million.  In connection with the sale of these properties the Bank
recorded aggregate losses of approximately $104 thousand.





Additionally,
more recent indications obtained from prospective buyers of these distressed
assets have given Management a more refined picture of how the market expects to
price certain types of properties in the current environment. This has provided
more evidence to extrapolate fair values for similar types of
collateral.





Land





At June
30, 2009, the balance of non-accruing land loans was approximately $0.5
million or $2.2 million lower than that reported at December 31,
2008.  During the first six months of 2009, the Bank moved
approximately $2.3 million in balances within this segment to OREO status
following charge-offs of approximately $1.0 million.  The Bank also
received approximately $0.4 million in principal payments, the majority of which
can be attributed to proceeds received from the guaranteed portion of one
loan.





At June
30, 2009, all non accruing balances were carried at their current fair
values.





Other
Real Estate Owned (“OREO”)





The
following table provides a summary for the year to date change in the balance of
OREO as of June 30, 2009:





For the six months ended(dollars in thousands)
                      
                      June 30, 2009Balance
      December 31, 2008
                      
                      $
                      1,337Additions
                      
                      
                      8,403Dispositions
                      
                      
                      (2,998
                      )Write-downs
                      
                      
                      (73
                      )Balance June 30, 2009
                      
                      $
                      6,669





As of
June 30, 2009, the balance of OREO was approximately $6.7 million, an increase
of approximately $3.8 million from the first quarter and $5.3 million higher
than that reported at December 31, 2008.  During the first six months
of 2009, the Bank sold four properties, resulting in a reduction in the balance
of OREO of approximately $3.0 million, as represented in the table
above.  The majority of OREO sales occurred during the second quarter,
with approximately $2.9 million moving out of OREO.




As
discussed in Note 10. Subsequent Events, to the consolidated financial
statements, the Bank closed escrow for the sale of three additional OREO
properties in late July 2009.  In connection with the sale of these
properties, the Bank received aggregate proceeds of approximately $2.5 million
and recognized an aggregate pre-tax loss of approximately $0.3 million in July
2009.  Two of these properties were classified as single family
residential  - spec and one property was classified as
land.


Total
Cash and Cash Equivalents





Total
cash and due from banks was $48.3 million and $24.6 million at June 30, 2009 and
December 31, 2008, respectively. This line item will vary depending on cash
letters from the previous night and actual cash on hand in the
branches.  Additionally, increased deposit balances are reflected in
higher balances of federal funds sold.


- 51
-




Management’s
Discussion and Analysis





Investment
Securities and Other Earning Assets





Other
earning assets are comprised of Federal Home Loan Bank stock, Federal Funds sold
(funds the bank lends on a short-term basis to other banks), investments in
securities and short-term interest bearing deposits at other financial
institutions. These assets are maintained for liquidity needs of the Bank,
collateralization of public deposits, and diversification of the earning asset
mix.





The table
below summarizes the year to date change in the balances of other earning assets
as of June 30, 2009:





June 30,
                      
                      
                      December 31,
                      
                      
                      Variance(dollars in thousands)
                      
                      2009
                      
                      
                      2008
                      
                      
                      dollar
                      
                      
                      percentageFederal
      Home Loan Bank stock
                      
                      $
                      5,828
                      
                      
                      $
                      5,123
                      
                      
                      $
                      705
                      
                      
                      
                      13.76
                      %Available
      for sale securities
                      
                      
                      75,726
                      
                      
                      
                      50,762
                      
                      
                      
                      24,964
                      
                      
                      
                      49.18
                      %Federal
      funds sold
                      
                      
                      32,675
                      
                      
                      
                      6,650
                      
                      
                      
                      26,025
                      
                      
                      
                      391.35
                      %Interest bearing deposits other financial
      institutions
                      
                      
                      119
                      
                      
                      
                      119
                      
                      
                      
                      -
                      
                      
                      
                      0.00
                      %Total other earning assets
                      
                      $
                      114,348
                      
                      
                      $
                      62,654
                      
                      
                      $
                      51,694
                      
                      
                      
                      82.51
                      %




Federal
Home Loan Bank (“FHLB”) Stock





As a
member of the Federal Home Loan Bank of San Francisco, the Bank is required to
hold a specified amount of FHLB capital stock based on the level of borrowings
the Bank has obtained from the FHLB.  As such, the amount of FHLB
stock the Bank carries can vary from one period to another based on among other
things the current liquidity needs of the Bank.  At June 30, 2009, the
Bank held approximately $5.8 million in FHLB stock, an increase of approximately
$0.7 million from that reported at December 31, 2008.





Available
for Sale Investment Securities





At June
30, 2009 the balance of available for sale investment securities was
approximately $75.7 million, $25.0 million or 49.2% higher than that reported at
December 31, 2008.  The change in the balance of the portfolio can be
attributed in large part to purchases the Bank made in the aggregate amount
$38.6 million, sales, calls and maturities of securities in the aggregate amount
of $5.9 million and principal pay downs totaling approximately $5.4
million.





The
Company manages its securities portfolio to provide a source of both liquidity
and earnings. The Bank has an Asset/Liability Committee that develops current
investment policies based upon its operating needs and market circumstance. The
Bank’s investment policy is formally reviewed and approved annually by the Board
of Directors. The Asset/Liability Committee of the Bank is responsible for
reporting and monitoring compliance with the investment policy. Reports are
provided to the Bank’s Board of Directors on a regular basis.





Securities
available-for-sale are carried at fair value, with related unrealized net gains
or losses, net of deferred income taxes, recorded as an adjustment to equity
capital.  At June 30, 2009 the securities portfolio had a net
unrealized loss, net of income taxes of approximately $2.5
million.  This represents an increase in the net unrealized loss
position of approximately $1.4 million when compared to that reported at
December 31, 2008.  The year to date decline in the fair value of the
securities portfolio can be attributed in large part to the decline in the value
of several mortgage related securities as a result of downgrades and continued
market concerns surrounding such investments.





The Bank
had a total of nine whole loan CMO’s in the investment portfolio as of June 30,
2009 with a remaining principal balance of approximately $17.2
million.  This when compared to the $18.9 million in remaining
principal reported at December 31, 2008, represents a decline of approximately
$1.7 million or 9.0%.  These securities had a net unrealized loss of
approximately $4.4 million at June 30, 2009.  This represents an
increase in the net unrealized loss of approximately $2.3 million or 91.3% from
that reported at December 31, 2008.





The Bank
continues to perform extensive analyses on the underlying tranches associated
with all CMOs in the portfolio.  By analyzing the tranche separate
from the “mother” security, the Bank has determined that there is no impairment
and as such, is not taking any action to write-down these securities. These
investment securities continue to demonstrate cash flows as expected, based on
pre-purchase analyses, and the credit support component of these tranches has
actually increased from the origination date.  As of June 30, 2009,
Management does not believe the decline in market value of these securities is
other than temporary.


- 52
-


Management’s
Discussion and Analysis


During
the third and fourth quarters of 2008, the credit markets came under significant
duress as investor and consumer confidence in the U.S. financial system became
significantly destabilized.  As a result, many financial institutions
in severe need of liquidity were forced to de-leverage for a variety of reasons,
selling significant portions of their investment holdings which in turn placed
considerable pressure on the values of many classes of investment
securities.  In particular, mortgage related securities came under
substantial pressure and the Bank’s portfolio was not completely immune to
this.  Although substantially all of the Bank’s mortgage related
securities are considered “investment grade,” overall lack of confidence in the
housing market, the inability of many consumers to meet their mortgage related
obligations, and the strong need for liquidity have, among other things, been
influential in placing pressure on the prices of these types of
securities.





The
majority of the Bank’s mortgage securities were issued by:  The
Government National Mortgage Association (“Ginnie Mae”), The Federal National
Mortgage Association (“Fannie Mae”), and The Federal Home Loan Mortgage
Corporation (“Freddie Mac”).  These securities carry the guarantee of
the issuing agencies.





All fixed
and adjustable rate mortgage pools contain a certain amount of risk related to
the uncertainty of prepayments of the underlying mortgages.  Interest
rate changes have a direct impact upon prepayment rates.  The Bank
uses computer simulation models to test the average life, duration, market
volatility and yield volatility of adjustable rate mortgage pools under various
interest rate assumptions to monitor volatility.  Stress tests are
performed quarterly.





Federal
Funds Sold





The year
to date increase in the balance of federal funds sold can be attributed in large
part to higher deposit balances.  The amount of federal funds sold can
vary widely on a daily basis depending on the cash position of the Bank which is
affected by numerous variables such as cash letters, incoming and outgoing wire
activity and loan funding needs. Management  continues to implement
strategies for deployment of excess funds, including the origination
of  high quality loans and investments in securities, while ensuring
the Bank continues to maintain appropriate levels of liquidity.





Deposits
and Borrowed Funds





The
following table provides a summary for the year to date change in various
categories of deposit balances as of June 30, 2009:





Variance Exclusive ofJune 30,
                            
                            
                            December 31,
                            
                            
                            Variance
                            
                            
                            Volatile Balances(dollars in thousands)
                            
                            2009
                            
                            
                            2008
                            
                            
                            dollar
                            
                            
                            percentage
                            
                            
                            dollar
                            
                            
                            percentageNon-interest
      bearing demand
                            
                            $
                            178,600
                            
                            
                            $
                            147,044
                            
                            
                            $
                            31,556
                            
                            
                            
                            21.46
                            %
                            
                            $
                            13,108
                            
                            
                            
                            8.91
                            %Interest
      bearing demand
                            
                            
                            64,723
                            
                            
                            
                            72,952
                            
                            
                            
                            (8,229
                            )
                            
                            
                            -11.28
                            %
                            
                            
                            10,982
                            
                            
                            
                            15.05
                            %Savings
                            
                            
                            24,792
                            
                            
                            
                            21,835
                            
                            
                            
                            2,957
                            
                            
                            
                            13.54
                            %
                            
                            
                            2,957
                            
                            
                            
                            13.54
                            %Money
      market
                            
                            
                            190,661
                            
                            
                            
                            173,199
                            
                            
                            
                            17,462
                            
                            
                            
                            10.08
                            %
                            
                            
                            18,134
                            
                            
                            
                            10.47
                            %Time deposits
                            
                            
                            206,708
                            
                            
                            
                            139,872
                            
                            
                            
                            66,836
                            
                            
                            
                            47.78
                            %
                            
                            
                            66,836
                            
                            
                            
                            47.78
                            %Total retail deposits
                            
                            
                            665,484
                            
                            
                            
                            554,902
                            
                            
                            
                            110,582
                            
                            
                            
                            19.93
                            %
                            
                            
                            112,017
                            
                            
                            
                            20.19
                            %Brokered
      time deposits
                            
                            
                            28,503
                            
                            
                            
                            20,117
                            
                            
                            
                            8,386
                            
                            
                            
                            41.69
                            %
                            
                            
                            8,386
                            
                            
                            
                            41.69
                            %Brokered money market funds
                            
                            
                            10,002
                            
                            
                            
                            28,502
                            
                            
                            
                            (18,500
                            )
                            
                            
                            -64.91
                            %
                            
                            
                            (18,500
                            )
                            
                            
                            -64.91
                            %Total brokered deposits
                            
                            
                            38,505
                            
                            
                            
                            48,619
                            
                            
                            
                            (10,114
                            )
                            
                            
                            -20.80
                            %
                            
                            
                            (10,114
                            )
                            
                            
                            -20.80
                            %Total deposits
                            
                            $
                            703,989
                            
                            
                            $
                            603,521
                            
                            
                            $
                            100,468
                            
                            
                            
                            16.65
                            %
                            
                            $
                            101,903
                            
                            
                            
                            16.88
                            %





Deposits





During
the first six months of 2009, the Bank placed considerable emphasis on the
acquisition of additional core deposits.  The focus on this initiative
proved to be successful as the Bank saw core deposit balances (non-interest and
interest bearing demand, savings, money market and time certificate accounts
with balances less than $100 thousand) increase approximately $68.8 million
during the first six months of 2009 from that reported at December 31, 2008,
with significant increases in non-interest bearing demand, money market and time
certificate of deposit accounts.


- 53
-




Management’s
Discussion and Analysis





In an
effort to rely less on FHLB borrowings and maintain an appropriate mix of
secondary funding, the Bank purchased brokered deposits to assist in the funding
of balance sheet growth and to provide an additional source of
liquidity.  At June 30, 2009, brokered deposit balances totaled
approximately $38.5 million, a decline of approximately $10.1 million from that
reported at December 31, 2008 and a decline $46.0 million from that reported at
March 31, 2009.  Declines in brokered funds can be attributed to the
significant growth in core deposits.





Volatile
Deposits





The Bank
monitors the balance of various accounts that it considers to be volatile for a
variety of reasons and provides this data to the Board of Directors on a regular
basis.  Accounts may be added to or removed from the volatile
liability dependency report when, based on Management’s judgment, it is
determined that these funds are not suitable for any form of long term
investment or that the risk associated with these funds leaving the Bank has
become minimal.  Typically a material change in the balances of these
accounts is reflected in the balance of federal funds sold.  At June
30, 2009, the aggregate balance of deposits the Bank considers to be volatile
was approximately $59.9 million or $1.6 million lower that that reported at
December 31, 2008.





The
following table provides a summary of the deposit balances the Bank considers to
be volatile as of June 30, 2009 and December 31, 2008:





Percent of
                      
                      
                      
                      
                      
                      Percent ofJune 30,
                      
                      
                      Total
                      
                      
                      December 31,
                      
                      
                      Total
                      
                      
                      Dollar(dollars in thousands)
                      
                      2009
                      
                      
                      Deposits
                      
                      
                      2008
                      
                      
                      Deposits
                      
                      
                      VarianceNon-interest
      bearing demand
                      
                      $
                      29,641
                      
                      
                      
                      4.2
                      %
                      
                      $
                      11,193
                      
                      
                      
                      1.9
                      %
                      
                      $
                      18,448Interest
      bearing demand
                      
                      
                      2,484
                      
                      
                      
                      0.4
                      %
                      
                      
                      21,695
                      
                      
                      
                      3.6
                      %
                      
                      
                      (19,211
                      )Savings
                      
                      
                      -
                      
                      
                      
                      0.0
                      %
                      
                      
                      196
                      
                      
                      
                      0.0
                      %
                      
                      
                      (196
                      )Money market deposits
                      
                      
                      27,810
                      
                      
                      
                      3.9
                      %
                      
                      
                      28,482
                      
                      
                      
                      4.7
                      %
                      
                      
                      (672
                      )Total volatile deposits
                      
                      $
                      59,935
                      
                      
                      
                      8.5
                      %
                      
                      $
                      61,566
                      
                      
                      
                      10.2
                      %
                      
                      $
                      (1,631
                      )





The year
to date decline in balances the Bank considers to be volatile can be attributed
in large part to declines in volatile interest bearing demand balances of
approximately $19.2 million.  The year to date decline within this
category is the result of two relationships leaving the Bank, the majority of
which are considered public funds.  These declines were partially
offset by a dramatic increase in volatile non-interest bearing demand
balances.  The customers that hold these deposits engage in mortgage
related activities.  As more and more home owners have moved to
re-finance existing mortgages, given the current rate environment, deposit
balances related to these customers have increased.  Management and
the Board of Directors are aware that as conditions in the market change these
relationships will be impacted.





Borrowed
Funds





The Bank
has a variety of sources from which it may obtain secondary
funding.  These sources include, among others, the FHLB, credit lines
established with correspondent banks and various sources that provide brokered
funds.  Borrowings are obtained for a variety of reasons which
include, but are not limited to, funding loan growth and the purchase of
investments in the absence of core deposits and to provide additional liquidity
to meet the demands of depositors.





At June
30, 2009, borrowings obtained from the FHLB comprised the majority of borrowed
funds.  The following table provides a summary of FHLB borrowings the
Bank had outstanding as of June 30, 2009:





(dollars
in thousands)





Amount
                                  
                                  
                                  Interest
                                  
                                  MaturityBorrowed
                                  
                                  
                                  Rate
                                  
                                  Variable/Fixed
                                  
                                  Date$
                                  55,000
                                  
                                  
                                  
                                  0.14
                                  %
                                  Variable
                                  
                                  Open10,000
                                  
                                  
                                  
                                  2.89
                                  %
                                  Fixed
                                  
                                  9/16/10$
                                  65,000
                                  
                                  
                                  
                                  0.56
                                  %





As
evidenced in the table above, the balance of FHLB borrowing as of June 30, 2009
was $65.0 million.  This represents a decline of approximately $44.0
million from the balance reported at December 31, 2008.  The year to
date decline can be attributed to higher deposit balances during the first six
months of 2009.


- 54
-




Management’s
Discussion and Analysis





In the
fourth quarter of 2007, the Company renewed a promissory note with Pacific Coast
Bankers Bank (“PCBB”) for a revolving line of credit in the amount of $3.5
million.  The Company pledged 646,598 shares (51%) of the Bank’s stock
as collateral for the loan. The note is revolving in nature for the first two
years. The terms of the note call for quarterly interest only payments for the
first two years with subsequent principal and interest payments for eight years
on a fully amortized basis.  At June 30, 2009 the interest rate on the
note was 3.25% and is variable, moving with prime. Under the terms of the
agreement, the Company will not incur any additional debt over $2.0 million
exclusive of inter-company debt and existing debt without the prior written
consent of PCBB.  In addition, the Bank must be “well” capitalized on
an on-going basis as defined by bank regulators.  At June 30, 2009,
the Company had no balance outstanding on this note.





On
September 17, 2004, the Bank issued a Letter of Credit in the amount of
approximately $11.7 million, which has since been reduced to $11.4 million, to a
customer in regard to a senior care facility. The Letter of Credit was issued
pursuant to a Letter of Credit Reimbursement Agreement between the Bank and the
FHLB. It is collateralized by a blanket lien with the FHLB that includes all
qualifying loans on the Bank’s balance sheet.  The letter of credit
was renewed in July 2009 and will expire in September 2010.





Capital





At June
30, 2009, the balance of stockholders’ equity was approximately $91.3
million.  This, when compared to the $70.0 million at December 31,
2008, represents an increase of approximately $21.3 million. The year to date
change in capital is due primarily to $21.0 million in Senior Preferred Stock
the Company issued to the U.S. Treasury as part of its participation in the
CPP.   Additionally, the year to date change is also attributed
to net income of $1.6 million, the impact of year-to-date share-based
compensation expense in the amount of $0.2 million, dividends paid and accretion
on senior preferred stock in the amount of $0.2 million, proceeds from the
exercise of options in the amount of $46 thousand and a decline in the balance
of accumulated other comprehensive income in the amount of $1.4
million.





Senior
Preferred Stock





On March
20, 2009, the Company issued $21.0 million in Senior Preferred Stock to the U.S.
Treasury as part of its participation in the CPP.  Pursuant to the
terms under the CPP, the Company is required to pay dividends on the Senior
Preferred Stock in an amount equal to 5% per annum for five years and 9% per
annum thereafter.  Dividends are cumulative and payable quarterly.
Pursuant to an interim rule issued by the Federal Reserve Board, effective
October 17, 2008, all $21.0 million of preferred stock the Company issued under
the CPP qualifies as Tier I Capital.





Pursuant
to the terms outlined under the CPP, the Company issued a warrant to the U.S.
Treasury in an amount equal to 15% of the preferred issuance or approximately
$3.2 million (611,650 shares).  The warrant is exercisable immediately
for a period of ten years at a price equal to the average closing price of the
Company’s common stock over the twenty day period ending the day prior to the
Company’s preliminary approval to participate in the CPP ($5.15 per
share).





For
additional information regarding the Company’s Senior Preferred Stock and its
participation in the CPP, see Note 9 of the consolidated financial statements
filed on this Form 10-Q.





Dividends





The
following table provides a summary of dividends the Company has paid on its
common stock over the last two years:





DividendAmount
                          
                          Declaration
                          
                          Record
                          
                          PayableDividend Type
                          
                          Per Share
                          
                          Date
                          
                          Date
                          
                          DateStock
      dividend
                          
                          
                          5
                          %
                          04/24/08
                          
                          05/02/08
                          
                          05/16/08Cash
      dividend
                          
                          $
                          0.08
                          
                          01/24/08
                          
                          02/01/08
                          
                          02/15/08Cash
      dividend
                          
                          $
                          0.08
                          
                          10/17/07
                          
                          11/02/07
                          
                          11/16/07Cash
      dividend
                          
                          $
                          0.08
                          
                          07/18/07
                          
                          08/03/07
                          
                          08/17/07Cash
      dividend
                          
                          $
                          0.08
                          
                          04/20/07
                          
                          05/04/07
                          
                          05/18/07





As
evidenced in the table above, on April 24, 2008, the Board of Directors declared
a stock dividend in the amount of 5% which was paid on May 16, 2008 to
shareholders of record on May 2, 2008.  Shares and earnings per share
for all prior periods have been adjusted to fully reflect the impact of the May
2008 stock dividend.  The Company paid no dividends on its common
stock during the first six months of 2009 and as part of its participation in
the U.S. Treasury’s CPP, must seek the approval of the Treasury before doing
so.


- 55
-


Management’s
Discussion and Analysis


Trust
Preferred Securities





On
October 27, 2006 the Company issued $8.2 million of Floating Rate Junior
Subordinated Debt Securities to Heritage Oaks Capital Trust II (“Trust II”), a
statutory trust created under the laws of the State of Delaware.  The
debt securities issued to Trust II are subordinated to effectively all
borrowings of the Company.  The Company used the proceeds from the
issuance for general corporate purposes, which included, but not limited:
capital contributions to the Bank, investments, payment of dividends, and
repurchases of our common stock.





On April
23, 2007, the Company redeemed all of the Floating Rate Junior Subordinated Debt
Securities it held associated with Heritage Oaks Capital Trust I, a wholly owned
subsidiary of Heritage Oaks Bancorp.  The redemption price was 100% of
the principal amount redeemed plus accrued and unpaid interest as of the
redemption date.  The Company paid $0.4 million for the standard
interest payment due April 22, 2007, plus a payment of $8.2 million for the
principal amount to be redeemed on that date.  These amounts were
funded from the Company’s general corporate reserves.  As a result of
the redemption of the securities associated with Heritage Oaks Capital Trust I,
the Trust was dissolved on June 1, 2007.





On
September 20, 2007, the Company issued $5.2 million of Junior Subordinated
Deferrable Interest Debentures to Heritage Oaks Capital Trust III (“Trust III”),
a statutory trust created under the laws of the State of Delaware. The debt
securities issued to Trust III are subordinated to effectively all borrowings of
the Company. The Company used the proceeds from the issuance to assist in the
acquisition of Business First, for general corporate purposes, and for capital
contributions to the Bank for future growth.





At June
30, 2009, the Company had at total of $13.4 million in Junior Subordinated
Deferrable Interest Debentures issued and outstanding.  As mentioned
in the preceding paragraphs, these securities have been issued to Trusts II and
III.  The debt securities are subordinated to effectively all
borrowings of the Company and can be redeemed at par if certain events occur
that impact the tax treatment, regulatory treatment or the capital treatment of
the issuance.  Upon the issuance of the debt securities, the Company
purchased a 3.1% minority interest in both Trusts II and III, totaling $248
thousand and $155 thousand, respectively.  The balance of the equity
of Trusts II and III is comprised of mandatory redeemable preferred securities
and is included in other assets.  Interest associated with the
securities issued to both Trusts II and III is payable quarterly at 3-month
LIBOR plus 1.72% variable rate and 6.888% fixed, respectively.





The
following table provides a summary of the securities the Company has issued to
Trusts II and III as of June 30, 2009:





Amount
                                    
                                    
                                    Current
                                    
                                    Issue
                                    
                                    Scheduled
                                    
                                    Call(dollars in thousands)
                                    
                                    Issued
                                    
                                    
                                    Rate
                                    
                                    Date
                                    
                                    Maturity
                                    
                                    Date
                                    
                                    Rate TypeHeritage
      Oaks Capital Trust II
                                    
                                    $
                                    8,248
                                    
                                    
                                    
                                    2.928
                                    %
                                    27-Oct-06
                                    
                                    Aug-37
                                    
                                    Nov-11
                                    
                                    Variable
      3-month LIBOR + 1.72%Heritage Oaks Capital Trust
    III
                                    
                                    
                                    5,155
                                    
                                    
                                    
                                    6.888
                                    %
                                    20-Sep-07
                                    
                                    Sep-37
                                    
                                    Dec-12
                                    
                                    5-year
      Fixed SWAP + 2.00%Total Issued
                                    
                                    $
                                    13,403
                                    
                                    
                                    
                                    4.45
                                    %





The
Company has the right under the indentures to defer interest payments for a
period not to exceed twenty consecutive quarterly periods (each an “Extension
Period”) provided that no extension period may extend beyond the maturity of the
debt securities.  If the Company elects to defer interest payments
pursuant to terms of the agreements, then the Company may not (i) declare or pay
any dividends or distributions on, or redeem, purchase, acquire or make a
liquidation payment with respect to any of the Company’s capital stock, or (ii)
make any payment of principal of or premium, if any, or interest on or repay,
repurchase or redeem any debt securities of the Company that rank pari passu
with or junior in interest to the Debt Securities, other than, among other
items, a dividend in the form of stock, warrants, options or other rights in the
same stock as that on which the dividend is being paid or ranks pari passu with
or junior to such stock. The prohibition on payment of dividends and payments on
pari passu or junior debt also applies in the case of an event of default under
the agreements.





Under FIN
No. 46, “Consolidation of
Variable Interest Entities, an interpretation of ARB No. 51,” the Company
is not allowed to consolidate Trusts II and III into the Company’s financial
statements.  Prior to the issuance of FIN No. 46, Bank holding
companies typically consolidated these entities.  On February 28,
2005, the Federal Reserve Board issued a rule which provides that,
notwithstanding the deconsolidation of such trusts, junior subordinated
debentures, such as those issued by the Company, may continue to constitute up
to 25% of a bank holding company's Tier I capital, subject to certain
limitations which were to become effective on March 31,
2009.  However, on March 17, 2009, the Federal Reserve Board issued a
ruling to delay the effective date of limitations on trust preferred securities
until March 31, 2011.    At June 30, 2009, the Company
included $13.0 million of the net junior subordinated debt in its Tier I Capital
for regulatory capital purposes.


- 56
-


Management’s
Discussion and Analysis


At June
30, 2009, the Company had sufficient cash to service the $13.4 million in junior
subordinated debenture interest payments for approximately 9 years without
dividends from subsidiaries. The Bank’s capacity to provide cash to the Company,
while remaining “well-capitalized”, was approximately $19.2 million at June 30,
2009.





Regulatory
Capital Requirements





Capital
ratios for commercial banks in the United States are generally calculated using
three different formulas.  These calculations are referred to as the
“Leverage Ratio” and two “risk-based” calculations known as: “Tier One Risk
Based Capital Ratio” and the “Total Risk Based Capital Ratio.”  These
standards were developed through joint efforts of banking authorities from
different countries around the world.  The standards essentially take
into account that different types of assets have different levels of risk
associated with them.  Furthermore, they take into account the
off-balance sheet exposures of banks when assessing capital
adequacy.





The
Leverage Ratio calculation simply divides common stockholders’ equity (reduced
by any goodwill a bank may have) by the total assets.  In the Tier One
Risk Based Capital Ratio, the numerator is the same as the leverage ratio, but
the denominator is the total “risk-weighted assets.” Risk weighted assets are
determined by segregating all the assets and off balance sheet exposures into
different risk categories and weighting them by a percentage ranging from 0%
(lowest risk) to 100% (highest risk).  The Total Risk Based Capital
Ratio again uses “risk-weighted assets” in the denominator, but expands the
numerator to include other capital items besides equity such as a limited amount
of the loan loss reserve, long-term capital debt, preferred stock and other
instruments.





The
following table provides a Summary of Company and Bank regulatory capital ratios
at June 30, 2009 and 2008:





Regulatory Standard
                
                
                June 30, 2009
                
                
                June 30, 2008Adequately
                
                
                Well
                
                
                Heritage Oaks
                
                
                Heritage OaksRatio
                
                Capitalized
                
                
                Capitalized
                
                
                Bancorp
                
                
                Bank
                
                
                Bancorp
                
                
                BankLeverage
      ratio
                
                
                4.00
                %
                
                
                5.00
                %
                
                
                10.87
                %
                
                
                10.33
                %
                
                
                8.87
                %
                
                
                8.64
                %Tier
      I capital to risk weighted assets
                
                
                4.00
                %
                
                
                6.00
                %
                
                
                11.95
                %
                
                
                11.23
                %
                
                
                9.66
                %
                
                
                9.38
                %Total
      risk based capital to risk weighted assets
                
                
                8.00
                %
                
                
                10.00
                %
                
                
                13.20
                %
                
                
                12.49
                %
                
                
                10.83
                %
                
                
                10.55
                %





Regulatory
capital ratios as of June 30, 2009 fully reflect the issuance of $21.0 million
in Senior Preferred Stock issued to the U.S. Treasury under the terms of the
CPP.  During the first six month of 2009, the holding company
down-streamed $17.0 million in capital to the Bank.  As previously
mentioned, pursuant to an interim rule issued by the Federal Reserve Board,
effective October 17, 2008, all $21.0 million of preferred stock the Company
issued qualifies as Tier I Capital, thus the Company’s and Bank’s capital ratios
as of June 30, 2009 increased significantly from that reported a year
earlier.





Liquidity





The
objective of liquidity management is to ensure the continuous availability of
funds to meet the demands of depositors, investors and
borrowers.  Asset liquidity is primarily derived from loan payments
and the maturity of other earning assets.  Liquidity from liabilities
is obtained primarily from the receipt of new deposits.  The Bank’s
Asset Liability Committee (“ALCO”) is responsible for managing the on and
off-balance sheet commitments to meet the needs of customers while achieving the
Bank’s financial objectives.  ALCO meets regularly to assess the
projected funding requirements by reviewing historical funding patterns, current
and forecasted economic conditions and individual customer funding
needs.  Deposits generated from the Bank’s customers serve as the
primary source of liquidity.  The Bank has credit arrangements with
correspondent banks that serve as a secondary liquidity source.  At
June 30, 2009, these credit lines totaled $20.0 million and the Bank had no
borrowings against those lines.  As previously mentioned the Bank is a
member of the FHLB and has collateralized borrowing capacities remaining of
$115.7 million at June 30, 2009.





The Bank
manages liquidity by maintaining a majority of the investment portfolio in
Federal Funds sold and other liquid investments.  The majority of
these investments include obligations of state and political subdivisions
(municipal bonds) and mortgage related securities that provide a relatively
steady stream of cash flows.  As of June 30, 2009, the Company
believes investments in the portfolio can be liquidated at their current fair
values in the event they are needed to provide liquidity.  The ratio
of liquid assets not pledged for collateral and other purposes to deposits and
other liabilities was 16.36% at June 30, 2009 compared to 6.79% at December 31,
2008.   At June 30, 2009, the Bank was within its internal
guideline for liquidity.  The ratio of net loans to deposits (“LTD”),
another key liquidity ratio, was 97.3% at June 30, 2009 compared to 110.7% at
December 31, 2008 both of which are and were within the Bank’s policy
guidelines.  While the Bank still provides the majority of loan
funding with core deposits, due to the highly competitive nature of deposit
gathering and given the current economic environment, the Bank has found it
necessary to rely on borrowed funds from time to time.  With the
banking industry’s common use of alternative funding sources, i.e. FHLB
borrowing, the Bank implemented a tracking ratio of Loan-to-Funding (“LTF”) in
2006.  This ratio is calculated by dividing gross loans by the sum of
total deposits and alternative funding sources both available and
used.  At June 30, 2009, the LTF ratio was 78.9%, compared to 87.2% at
December 31, 2008.  The Bank’s key focus has been and remains to
increase core deposits and minimize alternative funding
sources.


- 57
-


Management’s
Discussion and Analysis


The
following table provides a summary of the remaining borrowing capacity the
Company has with various secondary liquidity sources as of June 30,
2009:





(dollars in thousands)
                        
                        June 30, 2009Federal
      Home Loan Bank remaining borrowing capacity
                        
                        $
                        115,741Correspondent
      bank credit arrangements
                        
                        
                        20,000Brokered
      funds availability
                        
                        
                        127,866Revolving line of credit - Holding
      Company
                        
                        
                        3,500Total available secondary liquidity
      source
                        
                        $
                        267,107





During
the fourth quarter of 2008, a credit line previously established with a
correspondent bank in the amount of $20.0 million was temporarily
suspended.  Due to overall instability in the financial markets this
particular correspondent bank determined it necessary to re-assess all lines of
credit.  Management is currently in the process of working with this
and other correspondent banks in an effort to re-establish the
line.





The Bank
has a policy that permits the purchase of brokered funds in an amount not to
exceed 20% of total deposits.  As previously mentioned, Management has
purchased brokered funds in an effort to rely less on FHLB borrowings and
maintain an appropriate mix of secondary funding.  At June 30, 2009,
the balance of brokered funds was approximately $38.5 million or $10.1million
lower than that reported at December 31, 2008.  Brokered funds
represented 5.5% and 8.1% of total deposits as of June 30, 2009 and December 31,
2008, respectively.   Year to date increases in core deposits has
allowed the Bank to pay down brokered funds.





Inflation





The
assets and liabilities of a financial institution are primarily monetary in
nature.  As such they represent obligations to pay or receive fixed
and determinable amounts of money that are not affected by future changes in
prices.  Generally, the impact of inflation on a financial institution
is reflected by fluctuations in interest rates, the ability of customers to
repay their obligations and upward pressure on operating
expenses.  Although inflationary pressures are not considered to be of
any particular hindrance in the current economic environment, they may however
have an impact on the Company’s future earnings in the event those pressures do
become more prevalent.





Off-Balance
Sheet Arrangements





Off-balance
sheet arrangements are any contractual arrangement to which an unconsolidated
entity is a party, under which the Company has: (1) any obligation under a
guarantee contract; (2) a retained or contingent interest in assets transferred
to an unconsolidated  entity or similar arrangement that serves as
credit, liquidity or market risk support to that entity for such assets; (3) any
obligation under certain derivative instruments; or (4) any obligation under a
material variable interest held by the Company in an unconsolidated entity that
provides financing, liquidity, market risk or credit risk support to the
Company, or engages in leasing, hedging or research and development services
with the Company.





In the
ordinary course of business, the Company has entered into off-balance sheet
arrangements consisting of commitments to extend credit, commercial letters of
credit, and standby letters of credit. Such financial instruments are recorded
in the financial statements when they are funded or related fees are incurred or
received.  For a more detailed discussion of these financial
instruments, refer to Note 10 to the Company’s Consolidated Financial Statements
under Item 8 of Part II of the Company’s December 31, 2008 Annual Report filed
on Form 10-K.





In the
ordinary course of business, the Bank is a party to various operating
leases.  For a more detailed discussion of these financial
instruments, refer to Note 10 to the Company’s Consolidated Financial Statements
under Item 8 of Part II of the Company’s December 31, 2008 Annual Report filed
on Form 10-K.





In
connection with the $13.4 million in debt securities discussed under “Capital,” the Company issued
the full and unconditional payment guarantee of certain accrued
distributions.


- 58
-




Item
3.  Quantitative and Qualitative Disclosure About Market
Risk





As a
financial institution, the Company’s primary component of market risk is
interest rate volatility. Fluctuations in interest rates will ultimately impact
both the level of interest income and interest expense recorded on a large
portion of the Company’s assets and liabilities, and the market value of all
interest earning assets and interest bearing liabilities, other than those which
possess a short term to maturity. Virtually all of the Company’s interest
earning assets and interest bearing liabilities are located at the banking
subsidiary level. Thus, virtually all of the Company’s interest rate risk
exposure lies at the banking subsidiary level other than $13.4 million in
subordinated debentures issued by the Company’s subsidiary grantor trusts. As a
result, all significant interest rate risk procedures are performed at the
banking subsidiary level. The subsidiary Bank’s real estate loan portfolio,
concentrated primarily within Santa Barbara and San Luis Obispo Counties,
California, are subject to risks associated with the local economy.




The
fundamental objective of the Company’s management of its assets and liabilities
is to maximize the Company’s economic value while maintaining adequate liquidity
and an exposure to interest rate risk deemed by Management to be acceptable.
Management believes an acceptable degree of exposure to interest rate risk
results from the management of assets and liabilities through maturities,
pricing and mix to attempt to neutralize the potential impact of changes in
market interest rates. The Company’s profitability is dependent to a large
extent upon its net interest income, which is the difference between its
interest income on interest earning assets, such as loans and investments, and
its interest expense on interest bearing liabilities, such as deposits and
borrowings. The Company is subject to interest rate risk to the degree that its
interest earning assets re-price differently than its interest bearing
liabilities. The Company manages its mix of assets and liabilities with the
goals of limiting its exposure to interest rate risk, ensuring adequate
liquidity, and coordinating its sources and uses of funds.




The
Company seeks to control interest rate risk exposure in a manner that will allow
for adequate levels of earnings and capital over a range of possible interest
rate environments. The Company has adopted formal policies and practices to
monitor and manage interest rate risk exposure.  Management believes
historically it has effectively managed the effect of changes in interest rates
on its operating results and believes that it can continue to manage the
short-term effect of interest rate changes under various interest rate
scenarios.





Management
employs the use of an Asset and Liability Management software that is used to
measure the Bank’s exposure to future changes in interest rates. This model
measures the expected cash flows and re-pricing of each financial
asset/liability separately in measuring the Bank’s interest rate
sensitivity.  Based on the results of this model, Management believes
the Bank’s balance sheet is to a large extent “asset sensitive.”  This
means the Company expects (all other things being equal) to expand its net
interest income if rates rise and expects it conversely to contract if rates
fall.  The level of potential or expected contraction indicated by the
tables below is considered acceptable by Management and is compliant with the
Bank’s ALCO policies.  Management will continue to perform this analysis
each quarter to further validate the expected results against actual
data.




The
hypothetical impacts of sudden interest rate movements applied to the Company’s
asset and liability balances are modeled monthly. The results of these models
indicate how much of the Company’s net interest income is “at risk” from various
rate changes over a one year horizon. This exercise is valuable in identifying
risk exposures. Management believes the results for the Company’s June 30, 2009
balances indicate that the net interest income at risk over a one year time
horizon for a 1% and 2% rate increase and decrease is acceptable and within
policy guidelines at this time.





The
results in the table below indicate the change in net interest income the
Company would expect to see as of June 30, 2009, if interest rates were to
change in the amounts set forth:





Rate
      Shock Scenarios(dollars
      in thousands)
                  
                  -200bp
                  
                  
                  -100bp
                  
                  
                  Base
                  
                  
                  +100bp
                  
                  
                  +200bpNet
      interest income (NII)
                  
                  $
                  39,280
                  
                  
                  $
                  40,673
                  
                  
                  $
                  41,484
                  
                  
                  $
                  42,334
                  
                  
                  $
                  43,360$
      Change from base
                  
                  $
                  (2,204
                  )
                  
                  $
                  (811
                  )
                  
                  $
                  -
                  
                  
                  $
                  850
                  
                  
                  $
                  1,876%
      Change from base
                  
                  
                  -5.31
                  %
                  
                  
                  -1.95
                  %
                  
                  
                  0.00
                  %
                  
                  
                  2.05
                  %
                  
                  
                  4.52
                  %





It is
important to note that the above table is a summary of several forecasts and
actual results may vary. The forecasts are based on estimates and assumptions of
Management that may turn out to be different and may change over time. Factors
affecting these estimates and assumptions include, but are not limited to 1)
competitor behavior, 2) economic conditions both locally and nationally, 3)
actions taken by the Federal Reserve Board, 4) customer behavior and 5)
Management’s responses. Changes that vary significantly from the assumptions and
estimates may have significant effects on the Company’s net interest income;
therefore, the results of this analysis should not be relied upon as indicative
of actual future results.


- 59
-





The
following tables show Management’s estimates of how the loan portfolio is broken
out between variable-daily, variable at various time lines, fixed rate loans and
estimates of re-pricing opportunities for the entire loan portfolio at June 30,
2009:





(dollars
      in thousands)Percent
      ofRate
      Type
                        
                        Balance
                        
                        
                        TotalVariable
      - daily
                        
                        
                        275,892
                        
                        
                        
                        39.5
                        %Variable
      other than daily
                        
                        
                        263,717
                        
                        
                        
                        37.8
                        %Fixed
      rate
                        
                        
                        158,245
                        
                        
                        
                        22.7
                        %Total
      gross loans
                        
                        $
                        697,854
                        
                        
                        
                        100.0
                        %





The table
above identifies approximately 39.5% of the loan portfolio that will re-price
immediately in a changing rate environment.  At June 30, 2009,
approximately $539.6 million or 77.3% of the Bank’s loan portfolio is considered
variable.





(dollars
      in thousands)Percent
      ofRe-Pricing
                        
                        Balance
                        
                        
                        Total<
      1 Year
                        
                        $
                        403,798
                        
                        
                        
                        57.9
                        %1-3
      Years
                        
                        
                        171,065
                        
                        
                        
                        24.5
                        %3-5
      Years
                        
                        
                        72,470
                        
                        
                        
                        10.4
                        %>
      5 Years
                        
                        
                        50,521
                        
                        
                        
                        7.2
                        %Total
      gross loans
                        
                        $
                        697,854
                        
                        
                        
                        100.0
                        %





The
following table provides a summary of the loans the Bank can expect to see come
off their floors if the prime rate were to increase by the amounts identified
below as of June 30, 2009:





Move
      in Prime Rate (bps)(dollars
      in thousands)
                        
                        +200
                        
                        
                        +250
                        
                        
                        +300
                        
                        
                        +350Variable
      daily
                        
                        $
                        575
                        
                        
                        $
                        18,106
                        
                        
                        $
                        41,346
                        
                        
                        $
                        111,562Variable
      other than daily
                        
                        
                        2,647
                        
                        
                        
                        4,908
                        
                        
                        
                        50,962
                        
                        
                        
                        106,200Cumulative
      total variable at floor
                        
                        $
                        3,222
                        
                        
                        $
                        23,014
                        
                        
                        $
                        92,308
                        
                        
                        $
                        217,762





Given the
significant year over year decline in Prime rate, many loans in the portfolio
possess floors significantly higher than the current prime
rate.  Therefore, the Bank will need to see rates increase
significantly before the majority of loans in the portfolio start to come off
their floors.





Item
4.  Controls and Procedures





Evaluation
of Disclosure Controls and Procedures





As of the
end of the period covered by this report, the Company carried out an evaluation,
under the supervision and with the participation of its Management, including
the Company’s Chief Executive Officer and Chief Financial Officer, of the
effectiveness of the design and operation of the Company’s disclosure controls
and procedures pursuant to Exchange Act Rules 13a-15 and 15d-15. Based upon that
evaluation, the Chief Executive Officer and Chief Financial Officer concluded
that the Company’s disclosure controls and procedures are effective to provide
reasonable assurances that information required to be disclosed in the reports
the Company files or submits under the Securities Exchange Act of 1934 is
recorded, processed, summarized and reported within the time periods specified
in the SEC’s rules and forms.


- 60
-


Changes
in Internal Control Over Financial Reporting





There was
no change in the Company’s internal controls over financial reporting during the
quarter ended June 30, 2009 that has materially affected, or is reasonably
likely to materially affect, the Company’s internal controls over financial
reporting.





In
designing and evaluating disclosure controls and procedures, the Company’s
Management recognized that any controls and procedures, no matter how well
designed and operated, can provide only reasonable, not absolute, assurances of
achieving the desired control objectives and Management necessarily was required
to apply its judgment in evaluating the cost-benefit relationship of possible
controls and procedures.





Part
II.  Other Information





Item
1.  Legal Proceedings





The
Company is party to the following litigation:





Alpert,
et al v. Cuesta Title Company, et al.  San Luis Obispo County Sup. Ct. Case
no. CV 098220.  Plaintiffs have sued a title company, title
insurer, Hurst Financial and related individuals on a variety of
claims related to Hurst Financial's lending practices.  The Bank, which
made a commercial loan to a developer which also borrowed from Hurst Financial,
is named in two causes of action alleging (1) negligence and (2) aiding and
abetting Hurst Financial's allegedly illegal lending practices. 
The Bank did not lend to any of the plaintiffs or to Hurst Financial, nor
did the Bank have any contact whatsoever with the plaintiffs in relation to
their transactions with Hurst Financial.  The Bank has foreclosed upon
and now owns one of the properties Hurst Financial purportedly financed for
the developer using funds raised from the plaintiffs.  The Company
believes the action against it is without merit.  The matter has been
tendered to the Company's insurance carrier, and the Company is actively
defending the case.  The Company anticipates a favorable outcome to the
case and does not expect the litigation to have any significant financial impact
to the Company.





Item
1A.  Risk Factors





During
the period covered by this report there were no material changes from risk
factors as previously disclosed in the Company’s December 31, 2008 Annual Report
filed on Form 10-K in response to Item A to Part I of Form 10-K.





Item
2.  Unregistered Sales of Equity Securities and Use of
Proceeds





Unregistered
Sale of Equity Securities





None.





Purchases
of Equity Securities





None.





Item
3.  Defaults upon Senior Securities





None.


- 61
-


Item
4.  Submission of Matters to a Vote of Security Holders





The
annual meeting of shareholders of the Company was held on May 21, 2009, and
three matters were considered at the meeting:





1.
            The
      election of eleven persons to the Board of Directors of the Company to
      serve until the 2010 Annual Meeting of Shareholders and until their
      successors are elected and have qualified.  The following
      persons were elected with the following
votes:





Directors
                    
                    Votes
      For
                    
                    Votes
      Withheld
                    
                    %
      Votes ForMichael
      J. Morris
                    
                    6,238,014
                    
                    517,033
                    
                    80.47%Don
      Campbell
                    
                    6,148,288
                    
                    606,759
                    
                    79.31%Michael
      Behrman
                    
                    6,236,224
                    
                    518,823
                    
                    80.45%Kenneth
      Dewar
                    
                    6,244,995
                    
                    510,052
                    
                    80.56%Mark
      C. Fugate
                    
                    6,244,767
                    
                    510,280
                    
                    80.56%Dolores
      T. Lacey
                    
                    6,143,123
                    
                    611,924
                    
                    79.25%Merle
      F. Miller
                    
                    6,152,915
                    
                    602,132
                    
                    79.37%Daniel
      J. O'Hare
                    
                    6,244,995
                    
                    510,052
                    
                    80.56%Michael
      E. Pfau
                    
                    6,236,252
                    
                    518,795
                    
                    80.45%Alexander
      F. Simas
                    
                    6,244,995
                    
                    510,052
                    
                    80.56%Lawrence
      P. Ward
                    
                    6,198,365
                    
                    556,682
                    
                    79.96%





2.
            To
      adopt a non-binding resolution approving the Executive Compensation
      disclosed in the Proxy statement for the 2009 Annual Meeting of
      Shareholders dated April 24, 2009.  The resolution was adopted
      with the following votes:




Votes
      For
            
            Votes
      Against
            
            Votes
      Abstain
            
            %
      Votes For5,787,759
            
            843,736
            
            123,554
            
            74.66%








3.
            To
      ratify the appointment of Vavrinek, Trine, Day & Co., LLP as the
      Company’s independent accountants for the 2009 fiscal
  year.




Votes
      For
            
            Votes
      Against
            
            Votes
      Abstain
            
            %
      Votes For6,613,807
            
            68,711
            
            72,529
            
            85.32%




Item
5.  Other Information





Not
applicable.





Item
6.  Exhibits





(a)
Exhibits:





Exhibit
      (31.1)
            Certification
      of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002Exhibit
      (31.2)
            Certification
      of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002Exhibit
      (32.1)
            Certification
      of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002Exhibit
      (32.2)
            Certification
      of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002




- 62
-


Signatures





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





Heritage
      Oaks BancorpDate:
      August 10, 2009/s/ Lawrence P. WardLawrence
      P. WardPresidentChief
      Executive Officer/s/ Margaret A. TorresMargaret
      A. TorresExecutive
      Vice PresidentChief
      Financial Officer(Principal
      Financial and Accounting Officer)




- 63
-