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 September 30, 2010.





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
              incorporation
      or organization)
            
            (I.R.S.
      Employer
              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  ̈     Non-accelerated
filer  ̈    Smaller
reporting company x





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 November 9, 2010
there were 25,082,344 shares outstanding of the Registrant’s common
stock.










Part
I.  Financial Information





Item
1. Consolidated Financial Statements





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




Heritage
Oaks Bancorp | - 2 -


Heritage
Oaks Bancorp


and
Subsidiaries


Consolidated
Balance Sheets





(audited)September 30,
                                                                
                                                                
                                                                December 31,(dollars
      in thousands except per share data)
                                                                
                                                                2010
                                                                
                                                                
                                                                2009AssetsCash
      and due from banks
                                                                
                                                                $
                                                                16,681
                                                                
                                                                
                                                                $
                                                                19,342Interest
      bearing due from banks
                                                                
                                                                
                                                                34,936
                                                                
                                                                
                                                                
                                                                17,046Federal
      funds sold
                                                                
                                                                
                                                                5,500
                                                                
                                                                
                                                                
                                                                4,350Total
      cash and cash equivalents
                                                                
                                                                
                                                                57,117
                                                                
                                                                
                                                                
                                                                40,738Interest
      bearing deposits with other banks
                                                                
                                                                
                                                                119
                                                                
                                                                
                                                                
                                                                119Securities
      available for sale
                                                                
                                                                
                                                                202,218
                                                                
                                                                
                                                                
                                                                121,180Federal
      Home Loan Bank stock, at cost
                                                                
                                                                
                                                                5,395
                                                                
                                                                
                                                                
                                                                5,828Loans
      held for sale
                                                                
                                                                
                                                                12,374
                                                                
                                                                
                                                                
                                                                9,487Loans,
      net of deferred fees of $1,605 and $1,825 and allowance forloan
      loss of $21,571 and $14,372 at September 30, 2010 andDecember
      31, 2009, respectively.
                                                                
                                                                
                                                                650,706
                                                                
                                                                
                                                                
                                                                712,482Property,
      premises and equipment, net
                                                                
                                                                
                                                                6,216
                                                                
                                                                
                                                                
                                                                6,779Deferred
      tax assets
                                                                
                                                                
                                                                11,420
                                                                
                                                                
                                                                
                                                                10,553Bank
      owned life insurance
                                                                
                                                                
                                                                12,937
                                                                
                                                                
                                                                
                                                                12,549Goodwill
                                                                
                                                                
                                                                11,049
                                                                
                                                                
                                                                
                                                                11,049Core
      deposit intangible
                                                                
                                                                
                                                                2,256
                                                                
                                                                
                                                                
                                                                2,642Other
      real estate owned
                                                                
                                                                
                                                                9,031
                                                                
                                                                
                                                                
                                                                946Other
      assets
                                                                
                                                                
                                                                9,708
                                                                
                                                                
                                                                
                                                                10,825Total
      assets
                                                                
                                                                $
                                                                990,546
                                                                
                                                                
                                                                $
                                                                945,177LiabilitiesDepositsDemand,
      non-interest bearing
                                                                
                                                                $
                                                                176,419
                                                                
                                                                
                                                                $
                                                                174,635Savings,
      NOW, and money market deposits
                                                                
                                                                
                                                                384,080
                                                                
                                                                
                                                                
                                                                365,602Time
      deposits of $100 or more
                                                                
                                                                
                                                                118,443
                                                                
                                                                
                                                                
                                                                117,420Time
      deposits under $100
                                                                
                                                                
                                                                116,682
                                                                
                                                                
                                                                
                                                                117,808Total
      deposits
                                                                
                                                                
                                                                795,624
                                                                
                                                                
                                                                
                                                                775,465Short
      term FHLB borrowing
                                                                
                                                                
                                                                55,000
                                                                
                                                                
                                                                
                                                                65,000Junior
      subordinated debentures
                                                                
                                                                
                                                                8,248
                                                                
                                                                
                                                                
                                                                13,403Other
      liabilities
                                                                
                                                                
                                                                9,124
                                                                
                                                                
                                                                
                                                                7,558Total
      liabilities
                                                                
                                                                
                                                                867,996
                                                                
                                                                
                                                                
                                                                861,426Commitments
      and contingencies
                                                                
                                                                
                                                                -
                                                                
                                                                
                                                                
                                                                -Stockholders'
      EquitySeries
      A senior preferred stock, $1,000 per sharestated
      value, 21,000 shares issued and outstanding
                                                                
                                                                
                                                                19,701
                                                                
                                                                
                                                                
                                                                19,431Series
      C preferred stock, $3.25 per sharestated
      value, 1,189,538 shares issued and outstanding
                                                                
                                                                
                                                                3,604
                                                                
                                                                
                                                                
                                                                -Common
      stock, no par value; 100,000,000 shares authorized; issued
    andoutstanding:
      25,082,344 and 7,771,952 as of September 30, 2010 andDecember
      31, 2009, respectively.
                                                                
                                                                
                                                                101,140
                                                                
                                                                
                                                                
                                                                48,747Additional
      paid in capital
                                                                
                                                                
                                                                6,880
                                                                
                                                                
                                                                
                                                                3,242Retained
      (deficit) / earnings
                                                                
                                                                
                                                                (9,187
                                                                )
                                                                
                                                                
                                                                13,407Accumulated
      other comprehensive income / (loss), net of (tax) / tax benefit of
      ($288)and
      $752 as of September 30, 2010 and December 31, 2009,
      respectively.
                                                                
                                                                
                                                                412
                                                                
                                                                
                                                                
                                                                (1,076
                                                                )Total
      stockholders' equity
                                                                
                                                                
                                                                122,550
                                                                
                                                                
                                                                
                                                                83,751Total
      liabilities and stockholders' equity
                                                                
                                                                $
                                                                990,546
                                                                
                                                                
                                                                $
                                                                945,177





See notes
to condensed consolidated financial statements.


Heritage
Oaks Bancorp | - 3 -


Heritage
Oaks Bancorp


and
Subsidiaries


Consolidated
Statements of Income





For the three months
                          
                          
                          For the nine monthsended September 30,
                          
                          
                          ended September 30,(dollars in thousands except per share data)
                          
                          2010
                          
                          
                          2009
                          
                          
                          2010
                          
                          
                          2009Interest
      IncomeInterest
      and fees on loans
                          
                          $
                          10,908
                          
                          
                          $
                          10,703
                          
                          
                          $
                          33,478
                          
                          
                          $
                          33,266Interest
      on investment securitiesMortgage
      backed securities
                          
                          
                          1,442
                          
                          
                          
                          871
                          
                          
                          
                          3,886
                          
                          
                          
                          2,044Obligations
      of state and political subdivisions
                          
                          
                          329
                          
                          
                          
                          247
                          
                          
                          
                          873
                          
                          
                          
                          641Interest
      on time deposits with other banks
                          
                          
                          -
                          
                          
                          
                          1
                          
                          
                          
                          1
                          
                          
                          
                          3Interest
      on due from Federal Reserve Bank
                          
                          
                          20
                          
                          
                          
                          -
                          
                          
                          
                          72
                          
                          
                          
                          -Interest
      on federal funds sold
                          
                          
                          1
                          
                          
                          
                          21
                          
                          
                          
                          3
                          
                          
                          
                          38Interest
      on other securities
                          
                          
                          6
                          
                          
                          
                          17
                          
                          
                          
                          19
                          
                          
                          
                          33Total
      interest income
                          
                          
                          12,706
                          
                          
                          
                          11,860
                          
                          
                          
                          38,332
                          
                          
                          
                          36,025Interest
      ExpenseInterest
      on savings, NOW and money market deposits
                          
                          
                          705
                          
                          
                          
                          984
                          
                          
                          
                          2,589
                          
                          
                          
                          2,640Interest
      on time deposits in denominations of $100 or more
                          
                          
                          502
                          
                          
                          
                          695
                          
                          
                          
                          1,597
                          
                          
                          
                          1,870Interest
      on time deposits under $100
                          
                          
                          494
                          
                          
                          
                          675
                          
                          
                          
                          1,684
                          
                          
                          
                          1,903Other
      borrowings
                          
                          
                          163
                          
                          
                          
                          241
                          
                          
                          
                          533
                          
                          
                          
                          938Total
      interest expense
                          
                          
                          1,864
                          
                          
                          
                          2,595
                          
                          
                          
                          6,403
                          
                          
                          
                          7,351Net
      interest income before provision for possible loan losses
                          
                          
                          10,842
                          
                          
                          
                          9,265
                          
                          
                          
                          31,929
                          
                          
                          
                          28,674Provision
      for possible loan losses
                          
                          
                          4,400
                          
                          
                          
                          9,756
                          
                          
                          
                          25,700
                          
                          
                          
                          14,566Net
      interest income / (loss) after provision for possible loan
      losses
                          
                          
                          6,442
                          
                          
                          
                          (491
                          )
                          
                          
                          6,229
                          
                          
                          
                          14,108Non
      Interest IncomeFees
      and service charges
                          
                          
                          581
                          
                          
                          
                          750
                          
                          
                          
                          1,820
                          
                          
                          
                          2,214Other
      than temporary impairment (OTTI) losses on investment
      securities:Total
      impairment loss on investment securities
                          
                          
                          (650
                          )
                          
                          
                          -
                          
                          
                          
                          (650
                          )
                          
                          
                          -Non
      credit related losses recognized in other comprehensive
    income
                          
                          
                          544
                          
                          
                          
                          -
                          
                          
                          
                          544
                          
                          
                          
                          -Net
      impairment losses on investment securities
                          
                          
                          (106
                          )
                          
                          
                          -
                          
                          
                          
                          (106
                          )
                          
                          
                          -Gain
      on sale of investment securities
                          
                          
                          807
                          
                          
                          
                          211
                          
                          
                          
                          710
                          
                          
                          
                          333(Loss)
      / gain on sale of OREO
                          
                          
                          (28
                          )
                          
                          
                          (200
                          )
                          
                          
                          34
                          
                          
                          
                          (331
                          )Gain
      on sale of furniture fixtures and equipment
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          58
                          
                          
                          
                          -Gain
      on sale of SBA loans
                          
                          
                          -
                          
                          
                          
                          70
                          
                          
                          
                          209
                          
                          
                          
                          70Gain
      on extinguishment of debt
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          1,700
                          
                          
                          
                          -Other
                          
                          
                          1,253
                          
                          
                          
                          762
                          
                          
                          
                          3,281
                          
                          
                          
                          2,467Total
      non interest income
                          
                          
                          2,507
                          
                          
                          
                          1,593
                          
                          
                          
                          7,706
                          
                          
                          
                          4,753Non
      Interest ExpensesSalaries
      and employee benefits
                          
                          
                          4,799
                          
                          
                          
                          3,969
                          
                          
                          
                          13,528
                          
                          
                          
                          11,517Equipment
                          
                          
                          433
                          
                          
                          
                          365
                          
                          
                          
                          1,131
                          
                          
                          
                          1,066Occupancy
                          
                          
                          966
                          
                          
                          
                          843
                          
                          
                          
                          2,840
                          
                          
                          
                          2,521Reserve
      for unfunded loan commitments
                          
                          
                          65
                          
                          
                          
                          -
                          
                          
                          
                          65
                          
                          
                          
                          -Other
                          
                          
                          3,611
                          
                          
                          
                          5,074
                          
                          
                          
                          10,004
                          
                          
                          
                          10,586Total
      non interest expenses
                          
                          
                          9,874
                          
                          
                          
                          10,251
                          
                          
                          
                          27,568
                          
                          
                          
                          25,690Loss
      before provision for income taxes
                          
                          
                          (925
                          )
                          
                          
                          (9,149
                          )
                          
                          
                          (13,633
                          )
                          
                          
                          (6,829
                          )Income
      tax expense / (benefit)
                          
                          
                          9,978
                          
                          
                          
                          (3,907
                          )
                          
                          
                          4,444
                          
                          
                          
                          (3,196
                          )Net
      loss
                          
                          
                          (10,903
                          )
                          
                          
                          (5,242
                          )
                          
                          
                          (18,077
                          )
                          
                          
                          (3,633
                          )Dividends
      and accretion on preferred stock
                          
                          
                          357
                          
                          
                          
                          352
                          
                          
                          
                          4,517
                          
                          
                          
                          613Net
      loss applicable to common shareholders
                          
                          $
                          (11,260
                          )
                          
                          $
                          (5,594
                          )
                          
                          $
                          (22,594
                          )
                          
                          $
                          (4,246
                          )Loss
      Per Common ShareBasic
                          
                          $
                          (0.45
                          )
                          
                          $
                          (0.73
                          )
                          
                          $
                          (1.54
                          )
                          
                          $
                          (0.56
                          )Diluted
                          
                          $
                          (0.45
                          )
                          
                          $
                          (0.73
                          )
                          
                          $
                          (1.54
                          )
                          
                          $
                          (0.56
                          )





See notes
to condensed consolidated financial statements.


Heritage
Oaks Bancorp | - 4 -


Heritage
Oaks Bancorp


and
Subsidiaries


Consolidated
Statements of Stockholders' Equity





AccumulatedCommon Stock
                                            
                                            
                                            Additional
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            Other
                                            
                                            
                                            TotalPreferred
                                            
                                            
                                            Number of
                                            
                                            
                                            
                                            
                                            
                                            Paid-In
                                            
                                            
                                            Comprehensive
                                            
                                            
                                            Retained
                                            
                                            
                                            Comprehensive
                                            
                                            
                                            Stockholders'(dollars
      in thousands)
                                            
                                            Stock
                                            
                                            
                                            Shares
                                            
                                            
                                            Amount
                                            
                                            
                                            Capital
                                            
                                            
                                            Income
                                            
                                            
                                            Earnings
                                            
                                            
                                            Income/(Loss)
                                            
                                            
                                            EquityBalance,
      December 31, 2009
                                            
                                            $
                                            19,431
                                            
                                            
                                            
                                            7,771,952
                                            
                                            
                                            $
                                            48,747
                                            
                                            
                                            $
                                            3,242
                                            
                                            
                                            
                                            
                                            
                                            $
                                            13,407
                                            
                                            
                                            $
                                            (1,076
                                            )
                                            
                                            $
                                            83,751Issuance
      of 56,160 shares of Series B preferred stock
                                            
                                            
                                            52,351
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            52,351Discount
      on Series B preferred stock
                                            
                                            
                                            (3,456
                                            )
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            3,456Conversion
      of Series B preferred stock to common stock
                                            
                                            
                                            (52,351
                                            )
                                            
                                            
                                            17,279,995
                                            
                                            
                                            
                                            52,351
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            -Issuance
      of 1,189,538 shares of Series C preferred stock
                                            
                                            
                                            3,604
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            3,604Accretion
      on Series A preferred stock discount
                                            
                                            
                                            270
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            (270
                                            )
                                            
                                            
                                            
                                            
                                            
                                            
                                            -Accretion
      on Series B preferred stock discount
                                            
                                            
                                            3,456
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            (3,456
                                            )
                                            
                                            
                                            
                                            
                                            
                                            
                                            -Dividends
      paid on preferred stock
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            (262
                                            )
                                            
                                            
                                            
                                            
                                            
                                            
                                            (262
                                            )Accrued
      dividends and interest on preferred stock
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            (529
                                            )
                                            
                                            
                                            
                                            
                                            
                                            
                                            (529
                                            )Exercise
      of stock options
                                            
                                            
                                            
                                            
                                            
                                            
                                            11,260
                                            
                                            
                                            
                                            42
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            42Share-based
      compensation expense
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            182
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            182Issuance
      of restricted share awards
                                            
                                            
                                            
                                            
                                            
                                            
                                            26,565Retirement
      of restricted share awards
                                            
                                            
                                            
                                            
                                            
                                            
                                            (7,428
                                            )Comprehensive
      loss:Net
      loss
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            $
                                            (18,077
                                            )
                                            
                                            
                                            (18,077
                                            )
                                            
                                            
                                            
                                            
                                            
                                            
                                            (18,077
                                            )Unrealized
      security holding gains (net of $1,137 tax)
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            1,626
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            1,626
                                            
                                            
                                            
                                            1,626Reclassification
      for net gains on investments included in earnings(net of $97
      tax)
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            (138
                                            )
                                            
                                            
                                            
                                            
                                            
                                            
                                            (138
                                            )
                                            
                                            
                                            (138
                                            )Total
      comprehensive loss
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            $
                                            (16,589
                                            )Balance,
      September 30, 2010
                                            
                                            $
                                            23,305
                                            
                                            
                                            
                                            25,082,344
                                            
                                            
                                            $
                                            101,140
                                            
                                            
                                            $
                                            6,880
                                            
                                            
                                            
                                            
                                            
                                            
                                            $
                                            (9,187
                                            )
                                            
                                            $
                                            412
                                            
                                            
                                            $
                                            122,550Balance,
      December 31, 2008
                                            
                                            $
                                            -
                                            
                                            
                                            
                                            7,753,078
                                            
                                            
                                            $
                                            48,649
                                            
                                            
                                            $
                                            1,055
                                            
                                            
                                            
                                            
                                            
                                            
                                            $
                                            21,420
                                            
                                            
                                            $
                                            (1,092
                                            )
                                            
                                            $
                                            70,032Issuance
      of 21,000 shares of Series A Senior preferred stock and common stock
      warrant
                                            
                                            
                                            19,152
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            1,848
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            21,000Accretion
      on Series A preferred stock discount
                                            
                                            
                                            189
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            (189
                                            )
                                            
                                            
                                            
                                            
                                            
                                            
                                            -Dividends
      paid on preferred stock discount
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            (424
                                            )
                                            
                                            
                                            
                                            
                                            
                                            
                                            (424
                                            )Exercise
      of stock options (including $9 excess tax benefit from exercise of stock
      options)
                                            
                                            
                                            
                                            
                                            
                                            
                                            10,050
                                            
                                            
                                            
                                            46
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            46Share-based
      compensation expense
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            269
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            269Retirement
      of restricted share awards
                                            
                                            
                                            
                                            
                                            
                                            
                                            (2,623
                                            )Comprehensive
      income:Net
      loss
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            $
                                            (3,633
                                            )
                                            
                                            
                                            (3,633
                                            )
                                            
                                            
                                            
                                            
                                            
                                            
                                            (3,633
                                            )Unrealized
      security holding gains (net of $483 tax)
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            692
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            692
                                            
                                            
                                            
                                            692Reclassification
      for net gains on investments included in earnings (net of $137
      tax)
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            (196
                                            )
                                            
                                            
                                            
                                            
                                            
                                            
                                            (196
                                            )
                                            
                                            
                                            (196
                                            )Total
      comprehensive loss
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            $
                                            (3,137
                                            )Balance,
      September 30, 2009
                                            
                                            $
                                            19,341
                                            
                                            
                                            
                                            7,760,505
                                            
                                            
                                            $
                                            48,695
                                            
                                            
                                            $
                                            3,172
                                            
                                            
                                            
                                            
                                            
                                            
                                            $
                                            17,174
                                            
                                            
                                            $
                                            (596
                                            )
                                            
                                            $
                                            87,786





See notes
to condensed consolidated financial statements.


Heritage
Oaks Bancorp | - 5 -




Heritage
Oaks Bancorp


and
Subsidiaries


Consolidated
Statements of Cash Flows





For the nine month periodsended September 30,(dollars in thousands)
                          
                          2010
                          
                          
                          2009Cash
      flows from operating activities:Net
      loss
                          
                          $
                          (18,077
                          )
                          
                          $
                          (3,633
                          )Adjustments
      to reconcile net income to net cash (used) / provided by operating
      activities:Depreciation
      and amortization
                          
                          
                          967
                          
                          
                          
                          844Provision
      for possible loan losses
                          
                          
                          25,700
                          
                          
                          
                          14,566Amortization
      of premiums / discounts on investment securities, net
                          
                          
                          1,206
                          
                          
                          
                          64Amortization
      of intangible assets
                          
                          
                          386
                          
                          
                          
                          787Share-based
      compensation expense
                          
                          
                          182
                          
                          
                          
                          269Gain
      on sale of available for sale securities
                          
                          
                          (710
                          )
                          
                          
                          (333
                          )Other
      than temporary impairment
                          
                          
                          106
                          
                          
                          
                          -Gain
      on extinguishment of debt
                          
                          
                          (1,700
                          )
                          
                          
                          -(Increase)
      / decrease in loans held for sale
                          
                          
                          (2,887
                          )
                          
                          
                          161Net
      increase in bank owned life insurance
                          
                          
                          (388
                          )
                          
                          
                          (318
                          )Increase
      in deferred tax asset
                          
                          
                          (12,427
                          )
                          
                          
                          (5,017
                          )Deferred
      tax assets valuation allowance adjustment
                          
                          
                          10,519
                          
                          
                          
                          -(Gain)
      / loss on sale of other real estate owned
                          
                          
                          (34
                          )
                          
                          
                          331Write-downs
      on other real estate owned
                          
                          
                          362
                          
                          
                          
                          1,449Increase
      in other assets
                          
                          
                          (10,395
                          )
                          
                          
                          (8,218
                          )Increase
      in other liabilities
                          
                          
                          1,037
                          
                          
                          
                          260Excess
      tax benefit related to share-based compensation expense
                          
                          
                          -
                          
                          
                          
                          (9
                          )NET
      CASH (USED) / PROVIDED IN OPERATING ACTIVITIES
                          
                          
                          (6,153
                          )
                          
                          
                          1,203Cash
      flows from investing activities:Purchase
      of securities, available for sale
                          
                          
                          (105,382
                          )
                          
                          
                          (76,600
                          )Sale
      of available for sale securities
                          
                          
                          8,088
                          
                          
                          
                          16,040Maturities
      and calls of available for sale securities
                          
                          
                          556
                          
                          
                          
                          1,138Proceeds
      from principal reductions and maturities of available for sale
      securities
                          
                          
                          17,627
                          
                          
                          
                          8,424Purchase
      of Federal Home Loan Bank stock
                          
                          
                          -
                          
                          
                          
                          (705
                          )Redemption
      of Federal Home Loan Bank stock
                          
                          
                          433
                          
                          
                          
                          -Decrease
      / (increase) in loans, net
                          
                          
                          34,266
                          
                          
                          
                          (38,921
                          )Allowance
      for loan and lease loss recoveries
                          
                          
                          1,810
                          
                          
                          
                          30Purchase
      of property, premises and equipment, net
                          
                          
                          (404
                          )
                          
                          
                          (1,011
                          )Purchase
      of bank owned life insurance
                          
                          
                          -
                          
                          
                          
                          (377
                          )Proceeds
      from sale of other real estate owned
                          
                          
                          3,099
                          
                          
                          
                          6,269NET
      CASH USED IN INVESTING ACTIVITIES
                          
                          
                          (39,907
                          )
                          
                          
                          (85,713
                          )Cash
      flows from financing activities:Increase
      in deposits, net
                          
                          
                          20,159
                          
                          
                          
                          150,008Proceeds
      from Federal Home Loan Bank borrowing
                          
                          
                          35,000
                          
                          
                          
                          75,000Repayments
      of Federal Home Loan Bank borrowing
                          
                          
                          (45,000
                          )
                          
                          
                          (119,000
                          )Decrease
      in repurchase agreements
                          
                          
                          -
                          
                          
                          
                          (2,796
                          )Decrease
      in junior subordinated debentures
                          
                          
                          (3,455
                          )
                          
                          
                          -Excess
      tax benefit related to share-based compensation expense
                          
                          
                          -
                          
                          
                          
                          9Proceeds
      from exercise of stock options
                          
                          
                          42
                          
                          
                          
                          37Cash
      dividends paid
                          
                          
                          (262
                          )
                          
                          
                          (424
                          )Proceeds
      from issuance of preferred stock and common stock warrants,
      net
                          
                          
                          55,955
                          
                          
                          
                          21,000NET
      CASH PROVIDED BY FINANCING ACTIVITIES
                          
                          
                          62,439
                          
                          
                          
                          123,834Net
      increase in cash and cash equivalents
                          
                          
                          16,379
                          
                          
                          
                          39,324Cash
      and cash equivalents, beginning of period
                          
                          
                          40,738
                          
                          
                          
                          24,571Cash
      and cash equivalents, end of period
                          
                          $
                          57,117
                          
                          
                          $
                          63,895Supplemental
      Cash Flow Disclosures:Cash
      Flow informationInterest
      paid
                          
                          $
                          6,519
                          
                          
                          $
                          7,433Income
      taxes paid
                          
                          $
                          5,475
                          
                          
                          $
                          460Non-Cash
      Flow InformationChange
      in other valuation allowance for investment securities
                          
                          $
                          2,529
                          
                          
                          $
                          842Loans
      transferred to OREO or foreclosed collateral
                          
                          $
                          12,114
                          
                          
                          $
                          9,595Preferred
      stock dividends declared not paid
                          
                          $
                          529
                          
                          
                          $
                          -Accretion
      of preferred stock discount
                          
                          $
                          3,726
                          
                          
                          $
                          189Conversion
      of preferred stock
                          
                          $
                          52,351
                          
                          
                          $
                          -





See notes
to condensed consolidated financial statements.


Heritage
Oaks Bancorp | - 6 -




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 (“U.S. GAAP”) 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 2009 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 Bancorp (“the
Company”).  All significant inter-company balances and transactions
have been eliminated. Heritage Oaks Capital Trust II is an unconsolidated
subsidiary formed solely for the purpose of issuing trust preferred securities.
Operating results for the three and nine months ended September 30, 2010 are not
necessarily indicative of the results that may be expected for the year ending
December 31, 2010. Certain amounts in the consolidated financial statements for
the year ended December 31, 2009 and for the three and nine months ended
September 30, 2009 may have been reclassified to conform to the presentation of
the consolidated financial statements in 2010.





The
preparation of consolidated financial statements in conformity with U.S. GAAP
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.





Events or
transactions that provided evidence about conditions that did not exist at
September 30, 2010, but arose before the financial statements were available to
be issued have not been recognized in the financial statements as of and for the
periods ended September 30, 2010.  Based on all currently available
information, the Company is not aware of any such events.  Events or
transactions that were deemed to be of a material nature and provide evidence
about conditions that did exist at September 30, 2010 have been recognized in
these consolidated financial statements.





Note
2.  Investment Securities





In
accordance with U.S. GAAP, investment 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.


Heritage
Oaks Bancorp | - 7 -


Notes to
Consolidated Financial Statements




The
following table sets forth the amortized cost and fair values of investment
securities available for sale at September 30, 2010 and December 31,
2009:





(dollars in thousands)
                              
                              
                              
                              
                              Gross
                              
                              
                              GrossAmortized
                              
                              
                              Unrealized
                              
                              
                              Unrealized
                              
                              
                              FairAs of September 30, 2010
                              
                              Cost
                              
                              
                              Gains
                              
                              
                              Losses
                              
                              
                              ValueObligations
      of U.S. government agencies and corporations
                              
                              $
                              102
                              
                              
                              $
                              -
                              
                              
                              $
                              (3
                              )
                              
                              $
                              99Mortgage-backed
      securities:Agency
                              
                              
                              152,042
                              
                              
                              
                              1,784
                              
                              
                              
                              (842
                              )
                              
                              
                              152,984Non-agency
                              
                              
                              15,906
                              
                              
                              
                              251
                              
                              
                              
                              (1,849
                              )
                              
                              
                              14,308Obligations
      of state and political subdivisions
                              
                              
                              33,359
                              
                              
                              
                              1,385
                              
                              
                              
                              (26
                              )
                              
                              
                              34,718Other
      securities
                              
                              
                              109
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              109Total
                              
                              $
                              201,518
                              
                              
                              $
                              3,420
                              
                              
                              $
                              (2,720
                              )
                              
                              $
                              202,218As
      of December 31, 2009Obligations
      of U.S. government agencies
                              
                              $
                              108
                              
                              
                              $
                              -
                              
                              
                              $
                              (4
                              )
                              
                              $
                              104Mortgage-backed
      securities:Agency
                              
                              
                              78,203
                              
                              
                              
                              619
                              
                              
                              
                              (872
                              )
                              
                              
                              77,950Non-agency
                              
                              
                              21,935
                              
                              
                              
                              1,184
                              
                              
                              
                              (2,966
                              )
                              
                              
                              20,153Obligations
      of state and political subdivisions
                              
                              
                              22,653
                              
                              
                              
                              421
                              
                              
                              
                              (210
                              )
                              
                              
                              22,864Other
      securities
                              
                              
                              109
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              109Total
                              
                              $
                              123,008
                              
                              
                              $
                              2,224
                              
                              
                              $
                              (4,052
                              )
                              
                              $
                              121,180





During
the nine months ended September 30, 2010 the Company purchased approximately
$105.4 million in investment securities.  Sales of investments totaled
approximately $8.1 million.  In connection with these sales, the
Company recognized an aggregate pre-tax gain of $0.7 million.  Sales
of investment securities during the first nine months of 2009 totaled
approximately $16.0 million.  Gains recognized in connection with
those sales totaled approximately $0.3 million.  Principal pay-downs
on mortgage related securities totaled approximately $17.9 million and $8.4
million during the first nine months of 2010 and 2009,
respectively.





Other
than Temporary Impairment





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 Company 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.





U.S. GAAP
states that OTTI is considered to have occurred: (1) if the Company intends
to sell the related securities; (2) if it is “more likely than not” the
Company will be required to sell the securities before recovery of its amortized
cost basis; or (3) the present value of expected future cash flows is not
sufficient to recover the entire amortized cost basis of the
securities.  If an investor is not required to or does not intend to
sell the security, it must still evaluate the expected future cash flows to be
received to determine if a credit loss has occurred.  In the event
that a credit loss has occurred, only the amount of impairment related to the
credit loss is recognized in earnings.  OTTI amounts related to all
other factors, such as market conditions, are recorded as a component of
accumulated other comprehensive income.





During
the third quarter of 2010, the Company recognized approximately $0.1 million in
OTTI credit losses on one non-agency whole loan CMO.  Gross unrealized
losses on this one security were approximately $0.6 million, with approximately
$0.5 million related to all other factors, including general market conditions,
and recognized as a component of other comprehensive income.  During
the fourth quarter of 2009, the Company recognized OTTI credit losses on this
particular security of approximately $0.2 million.




Although
as of the date of evaluation the Company had the ability and intent to hold the
related security it evaluated for OTTI for the foreseeable future, the results
of the analysis performed on this security indicated that the present value of
the expected future cash flows was not sufficient to recover the entire
amortized cost basis, and thus indicating a credit loss had
occurred.




Heritage
Oaks Bancorp | - 8 -




Notes to
Consolidated Financial Statements





As of
September 30, 2010 the Company held three securities in which OTTI losses had
been recognized.  These securities had an aggregate remaining book
balance of approximately $3.6 million, compared to the $5.4 million reported at
December 31, 2009.  During the second quarter of 2010 the Company sold
one of four securities on which OTTI had previously been recognized, in an
effort to take advantage of current, more favorable, market pricing available at
that time.  The Company recognized a loss of approximately $150
thousand on the sale of that security.  The Company did not sell any
of the other securities mentioned above during the third quarter of 2010 and
therefore, continues to hold a total of three securities with
OTTI.  The Company will continue to engage an independent third party
to review these securities on a quarterly basis for the foreseeable
future.





The
Company’s evaluations of non-agency whole loan CMOs, with the assistance of an
independent third party, compile relevant collateral details and performance
statistics on a security-by-security basis.  These evaluations also
include assumptions about prepayment rates, future delinquencies, and loss
severities based on the underlying collateral characteristics, and
vintage.  Additionally, evaluations include consideration of actual
recent collateral performance, the structuring of the security, including the
Company’s position within that structure, and expectations of relevant market
and economic data as of the end of the reporting period.  Assumptions
made concerning the items listed above allow the Company to then derive an
estimate for the net present value of each security’s expected future cash
flows.  This amount is then compared to the amortized cost of each
security to determine the amount of any possible credit loss.





As of
September 30, 2010, net unrealized losses on non-agency CMOs within the
Company’s investment portfolio totaled approximately $1.6 million compared to
$1.8 million reported at December 31, 2009 and were primarily attributable to
market interest rate volatility and a significant widening of interest rate
spreads relating to the continued uncertainty in financial markets, rather than
to credit risk.  Current characteristics of each security owned, such
as delinquency rates, foreclosure levels, credit enhancements, and projected
losses, are reviewed periodically by Management.  Accordingly, it is
expected that these securities would not be settled at a price less than the
amortized cost of the Company’s investment. Because the Company does not have
the intent to sell these investments and it is not more likely than not that the
Company will be required to sell these investments before anticipated recovery
of fair value, which may be at maturity, the Company did not consider these
investments to be other than temporarily impaired as of September 30,
2010.  However, it is possible that the underlying loan collateral of
these securities will perform worse than is currently expected, which could lead
to adverse changes in cash flows on these securities and future OTTI
losses.  Events that could trigger material unrecoverable declines in
fair values, and therefore potential OTTI losses for these securities in the
future, include, but are not limited to, further significantly weakened economic
conditions, deterioration of credit metrics, significantly higher levels of
default, loss in value on the underlying collateral, deteriorating credit
enhancement, and further uncertainty and illiquidity in the financial
markets.





As of
September 30, 2010, the Company believes that unrealized losses on all other
mortgage related securities such as agency securities, including those issued by
the Federal Home Loan Mortgage Corporation (“FHLMC”), the Federal National
Mortgage Association (“FNMA”) and the Government National Mortgage Association
(“GNMA”) are not attributable to credit quality, but rather fluctuations in
market prices for these types of investments.  Additionally, these
securities have maturity dates that range from 1 to 30 years and have
contractual cash flows guaranteed by agencies of the U.S.
Government.  As of September 30, 2010, the Company does not believe
unrealized losses related to these securities are other than
temporary.





The
following table provides a roll forward as of September 30, 2010 of investment
securities credit losses recorded in earnings.  The beginning balance
represents the credit loss component for which OTTI occurred on debt securities
in prior periods.  Additions represent the first time a debt security
was credit impaired or when subsequent credit impairments have occurred on
securities for which OTTI credit losses have been previously
recognized.  As previously discussed the Company did recorded
additional OTTI on one investment security in the amount of $0.1 million during
the three and nine months ended September 30, 2010.





OTTI Related toOTTI Related
                          
                          
                          All Other
                          
                          
                          Total(dollars in thousands)
                          
                          to Credit Loss
                          
                          
                          Factors
                          
                          
                          OTTIBalance,
      December 31, 2009
                          
                          $
                          372
                          
                          
                          $
                          1,584
                          
                          
                          $
                          1,956Additional
      charges on securities for which OTTI was previously
    recognized
                          
                          
                          106
                          
                          
                          
                          544
                          
                          
                          
                          650Realized
      losses for securities sold
                          
                          
                          (45
                          )
                          
                          
                          (70
                          )
                          
                          
                          (115
                          )Balance,
      September 30, 2010
                          
                          $
                          433
                          
                          
                          $
                          2,058
                          
                          
                          $
                          2,491


Heritage
Oaks Bancorp | - 9 -


Notes to
Consolidated Financial Statements




The
following table provides a summary of investment securities in an unrealized
loss position as of September 30, 2010 and December 31, 2009:





Securities In A Loss PositionFor Less Than 12 Months
                          
                          
                          For 12 Months or More
                          
                          
                          Total(dollars in thousands)
                          
                          Fair
                          
                          
                          Unrealized
                          
                          
                          Fair
                          
                          
                          Unrealized
                          
                          
                          Fair
                          
                          
                          UnrealizedAs of September 30, 2010
                          
                          Value
                          
                          
                          Loss
                          
                          
                          Value
                          
                          
                          Loss
                          
                          
                          Value
                          
                          
                          LossObligations
      of U.S. government agencies and corporations
                          
                          $
                          -
                          
                          
                          $
                          -
                          
                          
                          $
                          99
                          
                          
                          $
                          (3
                          )
                          
                          $
                          99
                          
                          
                          $
                          (3
                          )Mortgage-backed
      securities:Agency
                          
                          
                          84,468
                          
                          
                          
                          (841
                          )
                          
                          
                          75
                          
                          
                          
                          (1
                          )
                          
                          
                          84,543
                          
                          
                          
                          (842
                          )Non-agency
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          9,798
                          
                          
                          
                          (1,849
                          )
                          
                          
                          9,798
                          
                          
                          
                          (1,849
                          )Obligations
      of state and political subdivisions
                          
                          
                          2,254
                          
                          
                          
                          (22
                          )
                          
                          
                          150
                          
                          
                          
                          (4
                          )
                          
                          
                          2,404
                          
                          
                          
                          (26
                          )Total
                          
                          $
                          86,722
                          
                          
                          $
                          (863
                          )
                          
                          $
                          10,122
                          
                          
                          $
                          (1,857
                          )
                          
                          $
                          96,844
                          
                          
                          $
                          (2,720
                          )As
      of December 31, 2009Obligations
      of U.S. government agencies
                          
                          $
                          -
                          
                          
                          $
                          -
                          
                          
                          $
                          104
                          
                          
                          $
                          (4
                          )
                          
                          $
                          104
                          
                          
                          $
                          (4
                          )Mortgage
      backed securities:Agency
                          
                          
                          38,625
                          
                          
                          
                          (870
                          )
                          
                          
                          357
                          
                          
                          
                          (2
                          )
                          
                          
                          38,982
                          
                          
                          
                          (872
                          )Non-agency
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          11,618
                          
                          
                          
                          (2,966
                          )
                          
                          
                          11,618
                          
                          
                          
                          (2,966
                          )Obligations
      of state and political subdivisions
                          
                          
                          6,012
                          
                          
                          
                          (210
                          )
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          6,012
                          
                          
                          
                          (210
                          )Total
                          
                          $
                          44,637
                          
                          
                          $
                          (1,080
                          )
                          
                          $
                          12,079
                          
                          
                          $
                          (2,972
                          )
                          
                          $
                          56,716
                          
                          
                          $
                          (4,052
                          )





At
September 30, 2010, the Company owned nine Whole Loan Private Label Mortgage
Backed Securities (“PMBS”) with a remaining principal balance of approximately
$15.9 million.  PMBS do not carry a government guarantee (explicit or
implicit) and require much more detailed due diligence in the form of pre and
post purchase analysis.  All PMBS bonds were rated AAA by one or more
of the major rating agencies at the time of purchase.  Due to the
severe and prolonged downturn in the economy PMBS bonds along with other asset
classes have seen deterioration in price, credit quality, and
liquidity.  Rating agencies have been reassessing all ratings
associated with bonds starting with lower tranche or subordinate pieces (which
have increased loss exposure) then moving on to senior and super senior bonds
which is what the Company owns with the exception of one mezzanine bond
(subordinate).  At September 30, 2010, five bonds with an aggregate
fair value of $9.6 million are deemed to be non-investment grade. All five of
these bonds are in senior or super senior tranche positions of their respective
bond structures, meaning the Company has priority in cash flows and has
subordinate tranches below its position providing credit support.





The
Company continues to perform regular extensive analyses, quarterly, on PMBS
bonds in the portfolio including but not limited to updates on: credit
enhancements, loan-to-values, credit scores, delinquency rates and default
rates. These investment securities continue to demonstrate cash flows as
expected, based on pre-purchase analyses.  As of September 30, 2010,
Management does not believe that losses on PMBS in the portfolio, other than
those previously discussed, are other than temporary.


Heritage
Oaks Bancorp | - 10 -




Notes to
Consolidated Financial Statements





Note
3.  Loans and the Allowance for Loan Losses





The
following table provides a summary of outstanding loan balances as of September
30, 2010 compared to December 31, 2009:





September 30,
                        
                        
                        December 31,(dollars in thousands)
                        
                        2010
                        
                        
                        2009Real
      Estate SecuredMulti-family
      residential
                        
                        $
                        20,475
                        
                        
                        $
                        20,631Residential
      1 to 4 family
                        
                        
                        23,358
                        
                        
                        
                        25,483Home
      equity lines of credit
                        
                        
                        30,627
                        
                        
                        
                        29,780Commercial
                        
                        
                        343,753
                        
                        
                        
                        337,940Farmland
                        
                        
                        15,364
                        
                        
                        
                        13,079CommercialCommercial
      and industrial
                        
                        
                        139,672
                        
                        
                        
                        157,270Agriculture
                        
                        
                        14,746
                        
                        
                        
                        17,698Other
                        
                        
                        194
                        
                        
                        
                        238ConstructionSingle
      family residential
                        
                        
                        8,972
                        
                        
                        
                        15,538Single
      family residential - Spec.
                        
                        
                        2,789
                        
                        
                        
                        3,400Tract
                        
                        
                        -
                        
                        
                        
                        2,215Multi-family
                        
                        
                        1,870
                        
                        
                        
                        2,300Hospitality
                        
                        
                        -
                        
                        
                        
                        14,306Commercial
                        
                        
                        32,307
                        
                        
                        
                        27,128Land
                        
                        
                        32,167
                        
                        
                        
                        52,793Installment
      loans to individuals
                        
                        
                        7,129
                        
                        
                        
                        8,327All
      other loans (including overdrafts)
                        
                        
                        459
                        
                        
                        
                        553Total
      loans, gross
                        
                        
                        673,882
                        
                        
                        
                        728,679Deferred
      loan fees
                        
                        
                        1,605
                        
                        
                        
                        1,825Allowance
      for loan losses
                        
                        
                        21,571
                        
                        
                        
                        14,372Total
      loans, net
                        
                        $
                        650,706
                        
                        
                        $
                        712,482Loans
      held for sale
                        
                        $
                        12,374
                        
                        
                        $
                        9,487





Concentration
of Credit Risk





At
September 30, 2010, approximately $511.7 million or 75.9% of the Company’s loan
portfolio was collateralized by various forms of real estate, this represents a
decrease of approximately $32.9 million when compared to that reported at
December 31, 2009. Such loans are generally made to borrowers located in San
Luis Obispo and Santa Barbara Counties. The Company 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 Company to significantly greater credit risk.





At
September 30, 2010, the Company was contingently liable for letters of credit
accommodations made to its customers totaling approximately $16.1 million and
un-disbursed loan commitments in the approximate amount of $142.0 million,
exclusive of letters of credit. The Company 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 Company 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 Company
currently anticipates no losses as a result of such transactions.  For
more detailed information on concentrations of credit risk, please refer to
“Loans” of “Financial Condition” under “Management’s Discussion and Analysis of
Results and Operations” contained within this document.


Heritage
Oaks Bancorp | - 11 -




Notes to
Consolidated Financial Statements







Loans
Serviced for Others





Loans
serviced for others are not included in the accompanying balance
sheets.  The unpaid principal balance of loans serviced for others,
exclusive of Small Business Administration (“SBA”) loans was $13.6 million and
$16.3 million at September 30, 2010 and December 31, 2009,
respectively.





The
Company originates SBA loans for sale to governmental agencies and institutional
investors.  At September 30, 2010 and December 31, 2009, the unpaid
principal balance of SBA loans serviced for others totaled $6.5 million and $4.4
million, respectively.  In accordance with U.S. GAAP, the Company
recognized $0 and approximately $0.2 million in gains on the sale of SBA loans
for the three and nine months ended September 30, 2010.  The Company
also recorded approximately $0 and $79 thousand in servicing assets related to
the sale of SBA loans during the three and nine months ended September 30,
2010.  These servicing assets are recoded initially at fair value and
will be amortized in proportion to and over the period of estimated net
servicing income associated with each SBA loan for which the Company provides
servicing.





The
following table provides a reconciliation of the change in net SBA servicing
assets for the three and nine months ended September 30, 2010:





For the three months ended
                    
                    
                    For the nine months endedSeptember 30,
                    
                    
                    September 30,(dollars in thousands)
                    
                    2010
                    
                    
                    2009
                    
                    
                    2010
                    
                    
                    2009Beginning
      balance
                    
                    $
                    59
                    
                    
                    $
                    (18
                    )
                    
                    $
                    (19
                    )
                    
                    $
                    (18
                    )Additions
                    
                    
                    -
                    
                    
                    
                    (11
                    )
                    
                    
                    79
                    
                    
                    
                    (11
                    )Disposals
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Amortization
                    
                    
                    (1
                    )
                    
                    
                    -
                    
                    
                    
                    (2
                    )
                    
                    
                    -Ending
      balance
                    
                    $
                    58
                    
                    
                    $
                    (29
                    )
                    
                    $
                    58
                    
                    
                    $
                    (29
                    )





U.S. GAAP
requires that the Company record the transfer of a portion of a financial asset
(such as SBA loans) as secured borrowing in its consolidated financial
statements until such time that the transfer of a portion of the financial asset
represents a participating interest and the transfer of the participating
interest has met the conditions for surrender of control, as
defined.





The
following summarizes the conditions that must be met to qualify as a
participating interest:





·
            The
      portions of a financial asset must represent a proportionate ownership
      interest in an entire financial
asset.


·
            From
      the date of transfer, all cash flows received from the entire financial
      asset must be divided proportionately among the participating interest
      holders in an amount equal to their share of
  ownership.


·
            The
      transfer of the financial asset shall involve no recourse (other than
      standard representation and warranties) to, or subordination by, any
      participating interest holder.


·
            No
      party has the right to pledge or exchange the entire financial
      asset.





If the
participating interest or surrender of control criteria are not met the transfer
of the financial asset is not accounted for as a sale and de-recognition of the
asset is not appropriate and the Company would continue to account for the
transfer as secured borrowing.





The
accounting guidance provided under U.S. GAAP has impacted the way the Company
accounts for the sale of SBA loans.  The terms contained in certain
participation and loan sale agreements, specifically those that relate to the
sale of SBA loans, are outside the control of the Company.  These
sales agreements contain recourse provisions (generally 90 days) that initially
require the Company to account for the transfer of a portion of these financial
assets as secured borrowing, until such time that the recourse provision
expires.  Once the recourse provision expires, transfers of a portion
of these financial assets are re-evaluated to determine if they meet the
participating interest definition and subsequently accounted for as a
sale.  As a result, the Company will report SBA transfers as secured
borrowings over the period for which recourse provisions exist, which will
result in the deferral of any potential gain on sale from these transactions,
assuming all other sales criteria for each transaction are met.


Heritage
Oaks Bancorp | - 12 -




Notes to
Consolidated Financial Statements





Impaired
Loans





The
following table provides a summary of the Company’s investment in impaired
loans, the corresponding valuation allowance for such loans as of September 30,
2010 and December 31, 2009:





September 30,
                          
                          
                          December 31,(dollars in thousands)
                          
                          2010
                          
                          
                          2009Non-accruing
      loans
                          
                          $
                          26,776
                          
                          
                          $
                          38,170Loans
      90 days or more past due and still accruing
                          
                          
                          52
                          
                          
                          
                          151Troubled
      debt restructurings (exclusive of loans on non accrual)
                          
                          
                          6,782
                          
                          
                          
                          9,703Total
      impaired loans
                          
                          $
                          33,610
                          
                          
                          $
                          48,024Impaired
      loans with a valuation allowance
                          
                          $
                          9,042
                          
                          
                          $
                          6,155Valuation
      allowance related to impaired loans
                          
                          $
                          1,922
                          
                          
                          $
                          852Impaired
      loans without a valuation allowance
                          
                          $
                          24,568
                          
                          
                          $
                          41,869Average
      recorded investment in impaired loans
                          
                          $
                          47,528
                          
                          
                          $
                          32,781Cash
      receipts applied to reduce principal balance
                          
                          $
                          15,854
                          
                          
                          $
                          7,042





The
provisions of U.S. GAAP permit the valuation allowances reported above to be
determined on a loan-by-loan basis or by aggregating loans with similar risk
characteristics.  Because all of the loans currently identified as
impaired have unique risk characteristics, valuation allowances the Company has
recorded were determined on a loan-by-loan basis.





Loans the
Company considers to be impaired totaled approximately $33.6 million and $48.0
million at September 30, 2010 and December 31, 2009,
respectively.  The Company classifies all non-accruing loans, loans 90
days or more past due and still accruing as well as loans classified as troubled
debt restructurings as impaired.  If interest on non-accruing loans
(including trouble debt restructurings (“TDRs”) on non-accrual) had been
recognized at the original interest rates stipulated in the respective loan
agreements, interest income would have been approximately $0.7 million and $2.4
million higher during the three and nine months ended September 30,
2010.  The Company recognized approximately $0.1 million and $0.4
million in interest income on certain loans classified as impaired for the three
and nine months ended September 30, 2010.  This compares to $11
thousand and $18 thousand in interest income recognized on impaired loans for
the same periods ended a year earlier.  Interest income recognition on
impaired loans related exclusively to TDRs that were performing under the
modified terms of their respective loan agreements. It should be noted that a
significant portion of the Company’s impaired loans were carried at fair value
as of September 30, 2010, resulting in large part from the charge-off of loan
balances following the receipt of appraisal information on the underlying
collateral.





At
September 30, 2010, approximately $13.9 million in loans were classified as TDRs
of which approximately $7.1 million were non-accruing.  In a majority
of cases, the Company has granted concessions regarding interest rates, payment
structure and maturity.  Forgone interest related to TDRs totaled
approximately $120 thousand and $197 thousand for the three and nine months
ended September 30, 2010.  This compares to the $17 thousand and $26
thousand reported in the same three and nine month periods ended a year
earlier.


Heritage
Oaks Bancorp | - 13 -




Notes to
Consolidated Financial Statements







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 uncollectible.





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 nine months ended
                  
                  
                  For the year endedSeptember 30,
                  
                  
                  September 30,
                  
                  
                  December 31,(dollars in thousands)
                  
                  2010
                  
                  
                  2009
                  
                  
                  2010
                  
                  
                  2009
                  
                  
                  2009Balance
      at beginning of period
                  
                  $
                  22,134
                  
                  
                  $
                  11,106
                  
                  
                  $
                  14,372
                  
                  
                  $
                  10,412
                  
                  
                  $
                  10,412Provision
      expense
                  
                  
                  4,400
                  
                  
                  
                  9,756
                  
                  
                  
                  25,700
                  
                  
                  
                  14,566
                  
                  
                  
                  24,066Loans
      charged-off:Residential
      1-4 family
                  
                  
                  316
                  
                  
                  
                  304
                  
                  
                  
                  598
                  
                  
                  
                  304
                  
                  
                  
                  558Home
      equity line of credit
                  
                  
                  1
                  
                  
                  
                  -
                  
                  
                  
                  1
                  
                  
                  
                  -
                  
                  
                  
                  -Commercial
      real estate
                  
                  
                  523
                  
                  
                  
                  41
                  
                  
                  
                  3,106
                  
                  
                  
                  41
                  
                  
                  
                  339Farmland
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  235
                  
                  
                  
                  -
                  
                  
                  
                  -Commercial
      and industrial
                  
                  
                  2,530
                  
                  
                  
                  503
                  
                  
                  
                  11,348
                  
                  
                  
                  1,728
                  
                  
                  
                  5,816Agriculture
                  
                  
                  44
                  
                  
                  
                  1,909
                  
                  
                  
                  1,253
                  
                  
                  
                  1,909
                  
                  
                  
                  2,224Construction
                  
                  
                  21
                  
                  
                  
                  397
                  
                  
                  
                  1,009
                  
                  
                  
                  2,218
                  
                  
                  
                  2,218Land
                  
                  
                  1,673
                  
                  
                  
                  1,801
                  
                  
                  
                  2,629
                  
                  
                  
                  2,792
                  
                  
                  
                  8,886Other
                  
                  
                  25
                  
                  
                  
                  42
                  
                  
                  
                  132
                  
                  
                  
                  143
                  
                  
                  
                  163Total
      charge-offs
                  
                  
                  5,133
                  
                  
                  
                  4,997
                  
                  
                  
                  20,311
                  
                  
                  
                  9,135
                  
                  
                  
                  20,204Recoveries
      of loans previously charged off
                  
                  
                  170
                  
                  
                  
                  8
                  
                  
                  
                  1,810
                  
                  
                  
                  30
                  
                  
                  
                  98Balance
      at end of period
                  
                  $
                  21,571
                  
                  
                  $
                  15,873
                  
                  
                  $
                  21,571
                  
                  
                  $
                  15,873
                  
                  
                  $
                  14,372





During
the three and nine months ended September 30, 2010, the Company made provisions
for loan losses in the amount of $4.4 million and $25.7 million,
respectively.  This when compared to the $9.8 million and $14.6
million reported for the same periods ended a year earlier, represents a
decrease of approximately $5.4 million and an increase of $11.1 million,
respectively.  Elevated provision expenses are reflective of, among
other things, additional loan balances charged-off during the nine months of
2010, continued weakness in local, state and national economic conditions, the
number and dollar volume of loans placed on non-accruing status when compared to
historical periods and the downgrade of certain credits within the loan
portfolio.


Heritage
Oaks Bancorp | - 14 -




Notes to
Consolidated Financial Statements





Note
4.  Other Real Estate Owned (“OREO”)





The
following table provides a summary of the change in the balance of OREO for the
nine months ended September 30, 2010:




Balance
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        BalanceDecember 31,
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        September 30,(dollars in thousands)
                        
                        2009
                        
                        
                        Additions
                        
                        
                        Disposals
                        
                        
                        Writedowns
                        
                        
                        2010Real
      Estate SecuredMulti-family
      residential
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        -Residential
      1 to 4 family
                        
                        
                        367
                        
                        
                        
                        235
                        
                        
                        
                        (198
                        )
                        
                        
                        (172
                        )
                        
                        
                        232Home
      equity line of credit
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Commercial
                        
                        
                        165
                        
                        
                        
                        5,590
                        
                        
                        
                        (363
                        )
                        
                        
                        (187
                        )
                        
                        
                        5,205Farmland
                        
                        
                        -
                        
                        
                        
                        577
                        
                        
                        
                        (577
                        )
                        
                        
                        -
                        
                        
                        
                        -CommercialCommercial
      and industrial
                        
                        
                        -
                        
                        
                        
                        50
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        50Agriculture
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Other
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -ConstructionSingle
      family residential
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Single
      family residential - Spec.
                        
                        
                        -
                        
                        
                        
                        538
                        
                        
                        
                        -
                        
                        
                        
                        (41
                        )
                        
                        
                        497Tract
                        
                        
                        -
                        
                        
                        
                        363
                        
                        
                        
                        -
                        
                        
                        
                        (69
                        )
                        
                        
                        294Multi-family
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Hospitality
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Commercial
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Land
                        
                        
                        414
                        
                        
                        
                        4,726
                        
                        
                        
                        (2,001
                        )
                        
                        
                        (386
                        )
                        
                        
                        2,753Installment
      loans to individuals
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -All
      other loans
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Totals
                        
                        $
                        946
                        
                        
                        $
                        12,079
                        
                        
                        $
                        (3,139
                        )
                        
                        $
                        (855
                        )
                        
                        $
                        9,031




Note
5.  Deferred Tax Assets





U.S. GAAP
requires that companies assess whether a valuation allowance should be
established against their deferred tax assets based on the consideration of all
available evidence using a “more likely than not” standard.  In making such
judgments, significant weight is given to evidence that can be objectively
verified.  U.S. GAAP provides that a cumulative loss in recent years is
significant negative evidence in considering whether deferred tax assets are
realizable and also restricts the amount of evidence on projections of future
taxable income to support the recovery of deferred tax assets.  As of
September 30, 2010, the Company recorded a $10.5 million valuation allowance
against its deferred tax assets, which was recognized as a charge to income tax
expense during the three months ended September 30, 2010.





The
ultimate realization of these deferred tax assets is dependent on the generation
of future taxable income during the periods in which those temporary differences
become deductible. Changes in existing tax laws could also affect actual tax
results and the valuation of deferred tax assets over time.  The deferred
tax assets for which there are no valuation allowances relate to amounts that
are expected to be realized through subsequent reversals of existing taxable
temporary differences.  The accounting for deferred taxes is based on an
estimate of future results.  Differences between anticipated and actual
outcomes of these future tax consequences could have an impact on the Company’s
consolidated results of operations or financial position.





The
deferred tax asset will be analyzed quarterly for changes affecting
realizability and the valuation allowance may be adjusted in future periods
accordingly.  The Company will analyze changes in near-term market
conditions and consider both positive and negative evidence as well as other
factors which may impact future operating results in making any decision to
adjust the valuation allowance in future periods.





Companies
are subject to a change in ownership test under Section 382 of the Internal
Revenue Code, that if met, would limit the annual utilization of pre-change of
ownership carry-forward as well as the ability to use certain unrealized
built-in losses (as determined by Section 382 testing).  As a result
of the Company’s March 2010 private placement, a change of ownership was deemed
to have occurred under Section 382.  Under Section 382, the yearly
limitation on the Company’s ability to utilize such deductions will be equal to
the product of the applicable long-term tax exempt rate and the sum of the
values of the Company’s common stock and TARP preferred stock immediately before
the ownership change.  The Company’s ability to utilize deductions
related to credit losses during the twelve month period following the deemed
ownership change would also be limited under Section 382, together with net
operating loss carry-forwards, to the extent that such deductions reflect a net
loss that was “built-in” to the Company’s assets immediately prior to the
ownership change.


Heritage
Oaks Bancorp | - 15 -




Notes to
Consolidated Financial Statements







Because
the amount of equity issued in the Company’s March 2010 private placement
triggered an ownership change under Section 382, the Company’s ability to use
the net operating loss carry-forwards and certain “built-in” losses existing at
the time of the deemed change in ownership to offset future income may be
substantially limited.  Therefore, the Company may incur higher than
anticipated income tax expense in future periods and / or may not fully realize
portions of its DTA subject to the Section 382 limitation.





Note
6.  Earnings / (Loss) Per Common Share





Basic
earnings / (loss) per common share are computed by dividing net income / (loss)
applicable to common shareholders by the weighted-average number of common
shares outstanding for the reporting period.  Diluted earnings /
(loss) per common share are computed by dividing net income available to common
shareholders by the weighted-average number of common shares outstanding over
the reporting period, 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, other share-based compensation awards and
any other security in which its conversion / exercise may result in the issuance
of common stock, such as the warrant the Company issued to the U.S. Treasury
during 2009 or the Series C Perpetual Preferred Stock the Company issued during
2010.  U.S. GAAP prohibits the computation of diluted loss per common
share from assuming exercise or issuance of securities that would have an
anti-dilutive effect, which can occur when the Company reports a net
loss..  As a result, any potential dilution associated with
share-based compensation awards, the warrant issued to the U.S. Treasury, and
the Series C Perpetual Preferred Stock were not included in the calculation of
diluted loss per common share for the three and nine months ended September 30,
2010, because the Company reported a net loss.





The
following table sets forth the number of shares used in the calculation of both
basic and diluted loss per common share for the three and nine months ended
September 30, 2010 and 2009:





For the three months ending,September 30, 2010
                                                  
                                                  
                                                  September 30, 2009Net
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  Net(dollars in thousands except per share
      data)
                                                  
                                                  Loss
                                                  
                                                  
                                                  Shares
                                                  
                                                  
                                                  Loss
                                                  
                                                  
                                                  SharesNet
      loss
                                                  
                                                  $
                                                  (10,903
                                                  )
                                                  
                                                  
                                                  
                                                  
                                                  $
                                                  (5,242
                                                  )Dividends
      and accretion on preferred stock
                                                  
                                                  
                                                  (357
                                                  )
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  (352
                                                  )Net
      loss applicable to common shareholders
                                                  
                                                  $
                                                  (11,260
                                                  )
                                                  
                                                  
                                                  
                                                  
                                                  $
                                                  (5,594
                                                  )Weighted
      average shares outstanding
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  25,004,479
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  7,699,377Basic
      loss per common share
                                                  
                                                  $
                                                  (0.45
                                                  )
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  $
                                                  (0.73
                                                  )Dilutive
      effect of share-based compensation awards, common stock warrants, and
      convertible perpetual preferred stock
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  -Weighted
      average diluted shares outstanding
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  25,004,479
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  7,699,377Diluted
      loss per common share
                                                  
                                                  $
                                                  (0.45
                                                  )
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  $
                                                  (0.73
                                                  )


Heritage
Oaks Bancorp | - 16 -


Notes to
Consolidated Financial Statements


For the nine months ending,September 30, 2010
                                        
                                        
                                        September 30, 2009Net
                                        
                                        
                                        
                                        
                                        
                                        Net(dollars in thousands except per share
      data)
                                        
                                        Loss
                                        
                                        
                                        Shares
                                        
                                        
                                        Loss
                                        
                                        
                                        SharesNet
      loss
                                        
                                        $
                                        (18,077
                                        )
                                        
                                        
                                        
                                        
                                        $
                                        (3,633
                                        )Dividends
      and accretion on preferred stock
                                        
                                        
                                        (4,517
                                        )
                                        
                                        
                                        
                                        
                                        
                                        (613
                                        )Net
      loss applicable to common shareholders
                                        
                                        $
                                        (22,594
                                        )
                                        
                                        
                                        
                                        
                                        $
                                        (4,246
                                        )Weighted
      average shares outstanding
                                        
                                        
                                        
                                        
                                        
                                        
                                        14,719,951
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        7,694,969Basic
      loss per common share
                                        
                                        $
                                        (1.54
                                        )
                                        
                                        
                                        
                                        
                                        
                                        $
                                        (0.56
                                        )Dilutive
      effect of share-based compensation awards, common stock warrants, and
      convertible perpetual preferred stock
                                        
                                        
                                        
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        -Weighted
      average diluted shares outstanding
                                        
                                        
                                        
                                        
                                        
                                        
                                        14,719,951
                                        
                                        
                                        
                                        
                                        
                                        
                                        
                                        7,694,969Diluted
      loss per common share
                                        
                                        $
                                        (1.54
                                        )
                                        
                                        
                                        
                                        
                                        
                                        $
                                        (0.56
                                        )





Note
7.  Recent Accounting Pronouncements





On
July 21, 2010, the Financial Accounting Standards Board (“FASB”) issued Accounting
Standards Update (“ASU”) No. 2010-20, “Receivables (Topic 310): Disclosures
about the Credit Quality of Financing Receivables and the Allowance for Credit
Losses.” The new disclosures will require significantly more information
about credit quality in a financial institution’s loan portfolio. This statement
addresses only disclosures and does not change recognition or measurement of the
allowance for loan losses. The provisions under this statement are effective for
interim and annual reporting periods beginning after December 15,
2010.





In April
2010, the FASB issued ASU No. 2010-18, “Effect of a Loan Modification When
the Loan Is Part of a Pool That Is Accounted for as a Single
Asset.”  ASU No. 2010-18 provides guidance on accounting for
acquired loans that have evidence of credit deterioration upon acquisition,
specifically those loans acquired and accounted for in the aggregate as a pool.
As a result of the amendments in this Update, modifications of loans that are
accounted for within a pool under Subtopic 310-30 do not result in the removal
of those loans from the pool even if the modification of those loans would
otherwise be considered a troubled debt restructuring. An entity will continue
to be required to consider whether the pool of assets in which the loan is
included is impaired if expected cash flows for the pool change.  The
Company is required to adopt the provisions of this ASU in its first interim
period beginning after July 15, 2010.  The Company does not currently
believe the adoption of this ASU will have a material impact on its consolidated
financial statements.





In
February 2010, the Financial FASB issued ASU No. 2010-09, “Subsequent Events (Topic
855) Amendments to Certain Recognition and disclosure
Requirements.”  The amendments remove the requirement for an
SEC registrant to disclose the date through which subsequent events were
evaluated.  Removal of the disclosure requirement did not have an
effect on the nature or timing of subsequent events evaluations performed by the
Company.  ASU 2010-09 became effective upon issuance.





In
January 2010, the FASB issued ASU No. 2010-06, “Fair Value Measurements and
Disclosures (Topic 820):  Improving Disclosures about Fair Value
Measurements.”  ASU 2010-06 revises two disclosure requirements
concerning fair value measurements and clarifies two others.  It
requires separate presentation of significant transfers into and out of Levels 1
and 2 of the fair value hierarchy and disclosure of the reasons for such
transfers.  It will also require the presentation of purchases, sales,
issuances, and settlements within Level 3 on a gross basis rather than a net
basis.  The amendments also clarify that disclosures should be
disaggregated by class of asset or liability and that disclosures about inputs
and valuation techniques should be provided for both recurring and non-recurring
fair value measurements.  These new disclosure requirements were
effective for the period ended March 31, 2010, except for the requirement
concerning gross presentation of Level 3 activity, which is effective for fiscal
years beginning after December 15, 2010.  The adoption of this ASU did
not have a material impact on the Company’s consolidated financial
statements.


Heritage
Oaks Bancorp | - 17 -




Notes to
Consolidated Financial Statements





In
December 2009, FASB issued an accounting standard incorporated into Accounting
Standards Codification (“ASC”) 860.  This update codifies SFAS
No. 166, “Accounting for
Transfers of Financial Assets—an Amendment of FASB Statement
No. 140,” which was previously issued by the FASB in June 2009 but
was not included in the original codification.  This update to ASC 860
creates more stringent conditions for reporting a transfer of a portion of a
financial asset as a sale, clarifies other sale-accounting criteria, and changes
the initial measurement of a transferor’s interest in transferred financial
assets. This statement is effective for all annual and interim reporting periods
beginning after November 15, 2009.  Under this standard, in order
to recognize the transfer of a portion of a financial asset as a sale, the
transferred portion and any portion that continues to be held by the transferor
must represent a participating interest, and the transfer of the participating
interest must meet the conditions for surrender of control. To qualify as a
participating interest: (i) the portions of a financial asset must
represent a proportionate ownership interest in an entire financial asset,
(ii) from the date of transfer, all cash flows received from the entire
financial asset must be divided proportionately among the participating interest
holders in an amount equal to their share of ownership, (iii) involve no
recourse (other than standard representation and warranties) to, or
subordination by, any participating interest holder, and (iv) no party has
the right to pledge or exchange the entire financial asset. If the participating
interest or surrender of control criteria are not met the transfer is not
accounted for as a sale and de-recognition of the asset is not
appropriate.  Rather the transaction is accounted for as a secured
borrowing arrangement. The impact to certain transactions such as the sale of
SBA loans or certain participations being reported as secured borrowings rather
than derecognizing a portion of a financial asset would increase total assets
(loans) and liabilities (other borrowings).  The terms contained in
certain participation and loan sale agreements are outside the control of the
Company and largely relate to Small Business Administration (“SBA”) loan
sales.  These sales agreements contain recourse provisions (generally
90 days) that will initially preclude sale accounting.  However, once
the recourse provision expires, transfers of portions of financial assets may be
reevaluated to determine if they meet the participating interest definition and
subsequently accounted for as a sale.  As a result, The Company will
report SBA transfers as secured borrowings over the period for which recourse
provisions exist, which will result in the deferral of any potential gain on
sale from these transactions, assuming all other sales criteria for each
transaction are met. The Company does not believe it has or will have a
significant amount of participations subject to recourse provisions or other
features that would preclude de-recognition of the assets
transferred.  The Company adopted this accounting standard on January
1, 2010 and has not had a material impact on the Company’s consolidated
financial statements.





In June
2009, the FASB issued an accounting standard, incorporated into ASC topic 810
“Consolidation,” that seeks to improve financial reporting by companies involved
with variable interest entities. Also addressed under this standard are concerns
about the application of certain key provisions, including those in which the
accounting and disclosures do not always provide timely and useful information
about a company’s involvement in a variable interest entity.  The
standard 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
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 standard is effective for all annual and interim
reporting periods beginning after November 15, 2009 with earlier application
prohibited.  The adoption of this standard did not have a material
impact on the Company’s financial statements.





In June
2009, the FASB issued an accounting standard which was incorporated into ASC
topic 860 “Transfers and Servicing.” This standard 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 adopted this accounting
standard on January 1, 2010 and the adoption did not have a material impact on
the Company’s financial statements.





In
December 2008, the FASB issued an accounting standard which was subsequently
incorporated into ASC topic 715 “Compensation – Retirement
Benefits.”  This standard 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 adopted this accounting standard on January 1,
2010.  The adoption of this standard did not have a material impact on
its financial statements.


Heritage
Oaks Bancorp | - 18 -




Notes to
Consolidated Financial Statements







Note
8.  Share-Based Compensation





As of
September 30, 2010, the Company had two share-based employee compensation plans,
which are more fully described in Note 15 of the consolidated financial
statements in the Company's Annual Report filed on Form 10-K for the year ended
December 31, 2009.  These plans include the “1997 Stock Option Plan”
and the “2005 Equity Based Compensation Plan.”  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 the fair market
value per share 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 nine months ended September 30, 2010 and 2009 is based
on awards ultimately expected to vest, and accordingly has been adjusted by the
amount of estimated forfeitures.  U.S. GAAP requires forfeitures to be
estimated at the time of grant and revised, if necessary, in subsequent periods
if actual forfeitures differ from those estimates.





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 nine months endedSeptember 30,
                          
                          
                          September 30,(dollars in thousands except share and per share data)
                          
                          2010
                          
                          
                          2009
                          
                          
                          2010
                          
                          
                          2009Share-based
      compensation expense:Stock
      option expense
                          
                          $
                          57
                          
                          
                          $
                          43
                          
                          
                          $
                          149
                          
                          
                          $
                          129Restricted
      stock expense
                          
                          
                          (63
                          )
                          
                          
                          42
                          
                          
                          
                          33
                          
                          
                          
                          140Total
      share-based compensation expense
                          
                          $
                          (6
                          )
                          
                          $
                          85
                          
                          
                          $
                          182
                          
                          
                          $
                          269Unrecognized
      compensation expense:Stock
      option expense
                          
                          $
                          562
                          
                          
                          $
                          274Restricted
      stock expense
                          
                          
                          152
                          
                          
                          
                          307Total
      unrecognized share-based compensation expense
                          
                          $
                          714
                          
                          
                          $
                          581





Share-based
compensation expense was negative for the third quarter of 2010, and relates to
the reversal of unvested restricted stock expense associated with the departure
of one of the Company’s executive officers.





At
September 30, 2010, there was a total of $562 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 2.7
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 September 30, 2010 was $152
thousand. That expense is expected to be recognized over the next 1.8
years.





The
aggregate intrinsic value in the following table represents the total pretax
intrinsic value (the difference between the Company’s closing stock price on the
last trading day of the third quarter of 2010 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 September 30,
2010).  The aggregate pretax intrinsic value is subject to change
based on the fair market value of the Company's stock.  There was no
aggregate intrinsic value associated with options that were exercised during
2010.   The pretax intrinsic value associated with options
exercised for the nine month period ended September 30, 2009 was approximately
$22 thousand.


Heritage
Oaks Bancorp | - 19 -




Notes to
Consolidated Financial Statements


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 September 30, 2010 and
2009:





AverageWeighted
                          
                          
                          Remaining
                          
                          
                          TotalAverage
                          
                          
                          Contractual
                          
                          
                          IntrinsicNumber of
                          
                          
                          Exercise
                          
                          
                          Term
                          
                          
                          ValueShares
                          
                          
                          Price
                          
                          
                          (in years)
                          
                          
                          (in 000's)Options
      outstanding, January 1, 2010
                          
                          
                          440,738
                          
                          
                          $
                          9.15Granted
                          
                          
                          311,813
                          
                          
                          
                          3.10Exercised
                          
                          
                          (11,260
                          )
                          
                          
                          3.73Forfeited
                          
                          
                          -
                          
                          
                          
                          -Options
      outstanding, September 30, 2010
                          
                          
                          741,291
                          
                          
                          $
                          6.69
                          
                          
                          
                          6.33
                          
                          
                          $
                          62Exercisable
      at September 30, 2010
                          
                          
                          361,475
                          
                          
                          $
                          9.51
                          
                          
                          
                          2.89
                          
                          
                          $
                          18Options
      outstanding, January 1, 2009
                          
                          
                          408,830
                          
                          
                          $
                          9.34Granted
                          
                          
                          49,741
                          
                          
                          
                          5.41Exercised
                          
                          
                          (10,050
                          )
                          
                          
                          3.73Forfeited
                          
                          
                          -
                          
                          
                          
                          -Options
      outstanding, September 30, 2009
                          
                          
                          448,521
                          
                          
                          $
                          9.03
                          
                          
                          
                          4.33
                          
                          
                          $
                          484Exercisable
      at September 30, 2009
                          
                          
                          347,172
                          
                          
                          $
                          8.92
                          
                          
                          
                          3.03
                          
                          
                          $
                          385





The
Company granted 229,313 options to Management and other Company employees and
82,500 to various non-management members of the Company’s Board of Directors
during the third quarter of 2010.  The Company also granted a
restricted share award of 26,565 shares to one member of management during the
third quarter of 2010.  During the first quarter of 2009 the Company
granted 25,000 options to various non-management members of the Company’s Board
of Directors.  The Company also granted 24,741 options to other
individuals during the first nine months of 2009.  The following table
presents the assumptions used in the calculation of the weighted average fair
value of options granted during the first nine months of 2009:





2010
                      
                      
                      2009Expected
      volatility
                      
                      
                      43.75
                      %
                      
                      
                      37.66
                      %Expected
      term (years)
                      
                      
                      7
                      
                      
                      
                      10Dividend
      yield
                      
                      
                      0.00
                      %
                      
                      
                      0.00
                      %Risk
      free rate
                      
                      
                      2.02
                      %
                      
                      
                      3.16
                      %Weighted-average
      grant date fair value
                      
                      $
                      1.48
                      
                      
                      $
                      2.87





The table
on the previous page presents the assumptions used to estimate the fair value of
stock options granted on the date of grant using the Black-Scholes pricing
model.  The Black-Scholes model incorporates a range of assumptions
for inputs that are disclosed in the table above.  Expected
volatilities are based on 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.


Heritage
Oaks Bancorp | - 20 -




Notes to
Consolidated Financial Statements







Note
9.  Fair Value Disclosures





The
Company determines the fair market values of certain financial instruments based
on the fair value hierarchy established in U.S. GAAP which requires an entity to
maximize the use of observable inputs and minimize the use of unobservable
inputs when measuring fair value and describes three levels of inputs that may
be used to measure fair value.





The
following provides a summary of the hierarchical levels 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 (“CDOs”) 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-accrual loans for
which it has established specific reserves as part of the specific credit
allocation 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 September 30, 2010, a significant majority
of the Company’s impaired loans were evaluated based on the fair value of their
underlying collateral based upon the most recent appraisal available to
Management.


Heritage
Oaks Bancorp | - 21 -




Notes to
Consolidated Financial Statements







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
assets.  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 assets.





The
following table provides a summary of the financial instruments the Company
measures at fair value on a recurring basis as of September 30,
2010:





Fair Value Measurements UsingQuoted Prices in
                          
                          
                          Significant Other
                          
                          
                          SignificantActive Markets for
                          
                          
                          Observable
                          
                          
                          Unobservable(dollars in thousands)
                          
                          Identical Assets
                          
                          
                          Inputs
                          
                          
                          Inputs
                          
                          
                          Assets AtAs of September 30, 2010
                          
                          (Level 1)
                          
                          
                          (Level 2)
                          
                          
                          (Level 3)
                          
                          
                          Fair ValueAssetsObligations
      of U.S. government agencies
                          
                          $
                          -
                          
                          
                          $
                          99
                          
                          
                          $
                          -
                          
                          
                          $
                          99Mortgage
      backed securitiesAgency
                          
                          
                          -
                          
                          
                          
                          152,984
                          
                          
                          
                          -
                          
                          
                          
                          152,984Non-agency
                          
                          
                          -
                          
                          
                          
                          14,308
                          
                          
                          
                          -
                          
                          
                          
                          14,308Obligations
      of state and political subdivisions
                          
                          
                          -
                          
                          
                          
                          34,422
                          
                          
                          
                          296
                          
                          
                          
                          34,718Other
      securities
                          
                          
                          -
                          
                          
                          
                          109
                          
                          
                          
                          -
                          
                          
                          
                          109Total
      assets measured on a recurring basis
                          
                          $
                          -
                          
                          
                          $
                          201,922
                          
                          
                          $
                          296
                          
                          
                          $
                          202,218As
      of December 31, 2009AssetsObligations
      of U.S. government agencies
                          
                          $
                          -
                          
                          
                          $
                          104
                          
                          
                          $
                          -
                          
                          
                          $
                          104Mortgage
      backed securitiesAgency
                          
                          
                          -
                          
                          
                          
                          77,950
                          
                          
                          
                          -
                          
                          
                          
                          77,950Non-agency
                          
                          
                          -
                          
                          
                          
                          20,153
                          
                          
                          
                          -
                          
                          
                          
                          20,153Obligations
      of state and political subdivisions
                          
                          
                          -
                          
                          
                          
                          22,127
                          
                          
                          
                          737
                          
                          
                          
                          22,864Other
      securities
                          
                          
                          -
                          
                          
                          
                          109
                          
                          
                          
                          -
                          
                          
                          
                          109Total
      assets measured on a recurring basis
                          
                          $
                          -
                          
                          
                          $
                          120,443
                          
                          
                          $
                          737
                          
                          
                          $
                          121,180





The
following table provides a summary of the changes in balance sheet carrying
values associated with Level 3 financial instruments during the nine months
ended September 30, 2010:





Purchases,Balance as of
                
                
                Gains
                
                
                Issuances, and
                
                
                Sales and
                
                
                Balance as of(dollars in thousands)
                
                December 31, 2009
                
                
                Included in OCI (1)
                
                
                Settlements
                
                
                Maturities
                
                
                September 30, 2010Obligations
      of state and political subdivisions
                
                $
                737
                
                
                $
                3
                
                
                $
                -
                
                
                $
                (444
                )
                
                $
                296





(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 classified as
obligations of state and political subdivisions represent available for sale
investment securities in the form of certificates of participation where an
active market for such securities is not currently available.


Heritage
Oaks Bancorp | - 22 -




Notes to
Consolidated Financial Statements







The
following table provides a summary of the financial instruments the Company
measures at fair value on a non-recurring basis as of September 30,
2010:





Fair Value Measurements UsingQuoted Prices in
                              
                              
                              Significant Other
                              
                              
                              SignificantActive Markets for
                              
                              
                              Observable
                              
                              
                              Unobservable(dollars in thousands)
                              
                              Identical Assets
                              
                              
                              Inputs
                              
                              
                              Inputs
                              
                              
                              Assets At
                              
                              
                              TotalAs of September 30, 2010
                              
                              (Level 1)
                              
                              
                              (Level 2)
                              
                              
                              (Level 3)
                              
                              
                              Fair Value
                              
                              
                              Gains / (Losses)AssetsImpaired
      loans
                              
                              $
                              -
                              
                              
                              $
                              31,688
                              
                              
                              $
                              -
                              
                              
                              $
                              31,688
                              
                              
                              $
                              (1,455
                              )Loans
      held for sale
                              
                              
                              -
                              
                              
                              
                              12,374
                              
                              
                              
                              -
                              
                              
                              
                              12,374Other
      real estate owned
                              
                              
                              -
                              
                              
                              
                              9,031
                              
                              
                              
                              -
                              
                              
                              
                              9,031
                              
                              
                              
                              (650
                              )Goodwill
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              11,049
                              
                              
                              
                              11,049Total
      assets measured on a non-recurring basis
                              
                              $
                              -
                              
                              
                              $
                              53,093
                              
                              
                              $
                              11,049
                              
                              
                              $
                              64,142
                              
                              
                              $
                              (2,105
                              )As
      of December 31, 2009AssetsImpaired
      loans
                              
                              $
                              -
                              
                              
                              $
                              47,172
                              
                              
                              $
                              -
                              
                              
                              $
                              47,172
                              
                              
                              $
                              (20,204
                              )Loans
      held for sale
                              
                              
                              -
                              
                              
                              
                              9,487
                              
                              
                              
                              -
                              
                              
                              
                              9,487
                              
                              
                              
                              -Other
      real estate owned
                              
                              
                              -
                              
                              
                              
                              946
                              
                              
                              
                              -
                              
                              
                              
                              946
                              
                              
                              
                              (1,496
                              )Goodwill
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              11,049
                              
                              
                              
                              11,049
                              
                              
                              
                              -Total
      assets measured on a non-recurring basis
                              
                              $
                              -
                              
                              
                              $
                              57,605
                              
                              
                              $
                              11,049
                              
                              
                              $
                              68,654
                              
                              
                              $
                              (21,700
                              )





Goodwill
assets are recorded at fair value initially and assessed for impairment
periodically thereafter under the provisions set forth in U.S.
GAAP.  During the fiscal year ended December 31, 2009, the carrying
amount of goodwill assets were compared to their fair value.  No
change in carrying amount resulted in accordance with the provisions set forth
in U.S. GAAP.





Note
10.  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.


Heritage
Oaks Bancorp | - 23 -




Notes to
Consolidated Financial Statements







The
following table provides a summary of the estimated fair value of financial
instruments at September 30, 2010 and December 31, 2009:





September 30, 2010
                  
                  
                  December 31, 2009Carrying
                  
                  
                  
                  
                  
                  Carrying(dollars in thousands)
                  
                  Amount
                  
                  
                  Fair Value
                  
                  
                  Amount
                  
                  
                  Fair ValueAssetsCash
      and cash equivalents
                  
                  $
                  57,117
                  
                  
                  $
                  57,117
                  
                  
                  $
                  40,738
                  
                  
                  $
                  40,738Interest
      bearing deposits
                  
                  
                  119
                  
                  
                  
                  119
                  
                  
                  
                  119
                  
                  
                  
                  119Investments
      and mortgage-backed securities
                  
                  
                  202,218
                  
                  
                  
                  202,218
                  
                  
                  
                  121,180
                  
                  
                  
                  121,180Federal
      Home Loan Bank stock
                  
                  
                  5,395
                  
                  
                  
                  5,395
                  
                  
                  
                  5,828
                  
                  
                  
                  5,828Loans
      receivable, net of deferred fees and costs
                  
                  
                  672,277
                  
                  
                  
                  676,232
                  
                  
                  
                  726,854
                  
                  
                  
                  731,045Loans
      held for sale
                  
                  
                  12,374
                  
                  
                  
                  12,374
                  
                  
                  
                  9,487
                  
                  
                  
                  9,487Bank
      owned life insurance
                  
                  
                  12,937
                  
                  
                  
                  12,937
                  
                  
                  
                  12,549
                  
                  
                  
                  12,549Accrued
      interest receivable
                  
                  
                  3,571
                  
                  
                  
                  3,571
                  
                  
                  
                  3,639
                  
                  
                  
                  3,639LiabilitiesNon-interest
      bearing deposits
                  
                  
                  176,419
                  
                  
                  
                  176,419
                  
                  
                  
                  174,635
                  
                  
                  
                  174,635Interest
      bearing deposits
                  
                  
                  619,205
                  
                  
                  
                  620,762
                  
                  
                  
                  600,830
                  
                  
                  
                  596,782Federal
      Home Loan Bank advances
                  
                  
                  55,000
                  
                  
                  
                  55,000
                  
                  
                  
                  65,000
                  
                  
                  
                  65,180Junior
      subordinated debentures
                  
                  
                  8,248
                  
                  
                  
                  7,710
                  
                  
                  
                  13,403
                  
                  
                  
                  12,390Accrued
      interest payable
                  
                  
                  474
                  
                  
                  
                  474
                  
                  
                  
                  590
                  
                  
                  
                  590





Notional
                  
                  
                  Cost to Cede
                  
                  
                  Notional
                  
                  
                  Cost to CedeAmount
                  
                  
                  or Assume
                  
                  
                  Amount
                  
                  
                  or AssumeOff-balance
      sheet instruments, commitments to extend credit and standby letters of
      credit
                  
                  $
                  158,148
                  
                  
                  $
                  1,581
                  
                  
                  $
                  169,578
                  
                  
                  $
                  1,696





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.





Interest
Bearing Deposits at Other Financial Institutions





The
carrying amounts reported in the balance sheet for interest bearing deposits at
other financial institutions approximates the fair value of these assets due to
the short-term nature of the assets.





Investments
Including Federal Home Loan 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
stock is based on carrying amounts due to redemption provisions.





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 loans and loans that possess a
rate variable other than daily) 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.


Heritage
Oaks Bancorp | - 24 -




Notes to
Consolidated Financial Statements







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.





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.





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.





Note
11.  Preferred Stock





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 Series A 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
carries a coupon of 5% for five years and 9% thereafter.  Senior
preferred stock issued to the U.S. Treasury is 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 warrant may be dilutive to
earnings per common share during reporting periods in which the warrant is not
anti-dilutive.





The U.S.
Treasury may transfer a portion or portions of the warrant, and/or exercise the
warrant at any time.  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 September 30, 2010, 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 Series A Senior
Preferred Stock and the warrant based on their relative fair
values.  The fair value of the Series A 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 Series A Senior Preferred
Stock and the warrant at approximately $19.2 million and $1.8 million,
respectively.  The Company is accreting the discount on the Series A
Senior Preferred Stock over a period of five years with corresponding charges to
retained earnings.


Heritage
Oaks Bancorp | - 25 -


Notes to
Consolidated Financial Statements




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 Series A Senior Preferred Stock and any dividends accrued
and paid from retained earnings on the Series A Senior Preferred
Stock.  For the three and nine months ended September 30, 2010,
dividends and accretion on the Series A Senior Preferred Stock totaled
approximately $0.4 million and $1.1 million,
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
      Series A Senior Preferred Stock cannot be redeemed for three years unless
      the Company obtains proceeds to replace the Series A 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”).
 
 In the
second quarter of 2010 the Company was required to defer dividend payments on
its Series A Senior Preferred Stock to comply with the terms of the Written
Agreement entered into between the Company and the Federal Reserve Company of
San Francisco.  As a result, as of September 30, 2010, the Company has
accrued for but has not paid approximately $0.5 million in dividends on its
Series A Senior Preferred Stock.  If the Company fails to pay
dividends on Series A Senior Preferred Stock for a total of six quarters,
whether or not consecutive, the U.S. Treasury will have the right to elect two
members of the Company’s Board of Directors, voting together with any other
holders of preferred shares ranking pari passu with the Series A
Senior Preferred Stock. These directors would serve on the Company’s Board of
Directors until such time as the Company has paid in full all dividends not
previously paid, at which time these directors’ terms of office would
immediately terminate.  As of September 30, 2010, the Company has not
paid dividends on Series A Preferred Stock for two consecutive
quarters.
 
 For more
information concerning the Written Agreement, please refer to Note 12.
Regulatory Order and Written Agreement of these consolidated financial
statements.
 
 Private
Placement and Preferred Stock Conversion
 
 On March
12, 2010 the Company announced that it completed a private placement of 52,088
shares of its Series B Mandatorily Convertible Adjustable Cumulative Perpetual
Preferred Stock ("Series B Preferred Stock") and 1,189,538 shares of its Series
C Convertible Perpetual Preferred Stock (“Series C Preferred Stock”), raising
gross proceeds of approximately $56.0 million. In addition, approximately $4.0
million was placed in escrow for a second closing of 4,072 shares of Series B
Preferred Stock, which then closed during the second quarter of
2010.  Total gross proceeds raised in the private placement were
approximately $60.0 million and total costs associated with the capital raising
efforts were approximately $4.0 million, which represent a reduction of the
addition to equity from the private placement.
 
 In June
2010, the Company received shareholder approval to convert all outstanding
shares of Series B Preferred Stock to common stock and as a result the Company
issued 17,279,995 shares of common stock in June 2010.
 
 The
Series B Preferred Stock was mandatorily convertible into common stock, upon the
approval by shareholders of the Company’s common stock at a conversion price of
$3.25 per common share.  As indicated above, shareholder approval
occurred during the second quarter of 2010.  The conversion price of
$3.25 per common share was less than the fair market value of the Company’s
common stock on March 10, 2010, (the “commitment date”) the date the Company
made a firm commitment to issue the Series B Preferred Stock.  The
fair market value of the Company’s common stock on the commitment date was $3.45
per share.  Therefore, the Series B Preferred Stock was issued with a
contingent beneficial conversion feature that had an intrinsic value equal to
the $0.20 per share difference between the share price on the commitment date
and the conversion price of the Series B Preferred Stock.  The
intrinsic value of the beneficial conversion feature related to the entire
Series B Preferred Stock issuance was $3.5 million.  The recognition
of the beneficial conversion feature was contingent upon the approval of the
Company’s shareholders of the conversion of the Series B Preferred Stock to
common stock and thus was recognized in June 2010 when such approval was
received at the Company’s annual meeting of shareholders.
  Heritage
Oaks Bancorp | - 26 -
  Notes to
Consolidated Financial Statements
 
  Upon
conversion of the Series B Preferred Stock the related beneficial conversion
feature was recorded in conjunction with the establishment of a discount on the
Series B Preferred Stock and a corresponding increase in additional paid in
capital.  The immediate accretion of the entire Series B Preferred
Stock discount occurred through a charge to retained earnings on June 11, 2010,
the date the Company converted the outstanding Series B Preferred Stock to
common stock.
 
 Series C
Preferred Stock is a non-voting class of stock substantially similar in priority
to the common stock of the Company, except for a liquidation preference over the
Company’s common stock.  The Series C Preferred Stock will convert to
shares of common stock on a one share for one share basis if the original holder
of such shares transfers them to an unaffiliated third party. The Series C
Preferred Stock will not be redeemable by either the Company or by the
holders.  Holders of the Series C Preferred Stock do not have any
voting rights, including the right to elect any directors, other than the
customary limited voting rights with respect to matters significantly and
adversely affecting the rights and privileges of the Series C Preferred
Stock.
 
 As is the
case with the Series B Preferred Stock, the fair market value of the Company’s
common stock was higher than the conversion price of $3.25 per share of the
Series C Preferred Stock on the date the Company made a firm commitment to issue
the Series C Preferred Stock.  Therefore, the Series C Preferred Stock
also has a contingent beneficial conversion feature associated with
it.  However, since the conversion of the Series C Preferred Stock
remains contingent upon the holder’s transfer of the securities to an
unaffiliated third party with no specified date for its conversion to common
stock, the Company will record the contingent beneficial conversion feature as
an initial discount on Series C Preferred Stock and additional paid in capital,
with a concurrent immediate accretion of the established discount and
corresponding charge to retained earnings on the date the Series C Preferred
Stock converts to common stock.  The amount of the contingent
beneficial conversion feature is approximately $0.2 million and will be recorded
as described upon the original holder’s transfer of Series C Preferred Stock to
an unaffiliated third party.  Such transfer has not occurred as of
September 30, 2010.
 
 It should
be noted that two investors in the Company’s March 2010 private placement have
Board observation rights, while one of the two investors also has Board
nomination rights.
 
 Note
12.  Regulatory Order and Written Agreement
 
 On March
4, 2010, the FDIC and the DFI issued a Consent Order (the "Order") to the Bank
that requires, among other things, the Bank to increase its capital ratios,
reduce its classified assets and increase Board oversight of Management. The
Board and Management are aggressively responding to the Order to ensure full
compliance and have taken actions necessary to comply with the Order within the
required time frames. Such actions include the completion of the capital raise
discussed above which, following a contribution of a portion of the proceeds to
the Bank, brought the Bank into compliance with the capital requirements of the
Order.  Additionally, a Written Agreement was entered into between the
Company and the Federal Reserve Bank of San Francisco on March 4,
2010.
 
 The
following provides a summary of certain provisions in the Order as well as the
Written Agreement.  Please also refer to the Company’s current reports
filed on Form 8-K with the SEC on March 10, 2010 and March 8, 2010, for a more
complete description of the provisions of the Order and Written Agreement,
respectively.
 
 Consent
Order
 
 On
February 26, 2010, the Bank stipulated to the issuance of the Order by the FDIC,
its principal federal banking regulator, and the California Department of
Financial Institutions (“DFI”) which requires the Bank to take certain measures
to improve its safety and soundness.  The Order was subsequently
issued by the FDIC and DFI on March 4, 2010. The Bank’s stipulation to the
issuance by the FDIC and the DFI of the Order resulted from certain findings in
a report of examination resulting from an examination of the Bank conducted in
September 2009 based upon financial and lending data measured as of June 30,
2009. In entering into the stipulation to entry of the Order, the Bank did not
concede the findings or admit to any of the assertions in the report of
examination (“ROE”).
 
 Under the
Order, the Bank is required to take certain measures as more fully discussed
below.  At September 30, 2010, the Bank believes it is in compliance
with all components of the Order.
 
 ·
              Among
      the corrective actions required are for the Bank to develop and adopt a
      plan to maintain the minimum capital requirements for a “well-capitalized”
      Bank, and to reach and maintain a Tier 1 leverage ratio of at least 10%
      and a total risked based capital ratio of 11.5% at the Bank level
      beginning 90 days from the issuance of the Order.  Following the
      Company’s March 2010 private placement, $48.0 million was down-streamed to
      the Bank in the form of Tier I capital, bringing the Bank’s regulatory
      capital ratios above the required minimums set forth in the
      Order.
  Heritage
Oaks Bancorp | - 27 -
  Notes to
Consolidated Financial Statements
 
 ·
              Pursuant
      to the Order, the Bank must retain qualified management, must notify the
      FDIC and the DFI in writing when it proposes to add any individual to its
      Board of Directors or to employ any new senior executive officer, and must
      conduct an independent study of management and personnel structure of the
      Bank. A consultant was retained to complete the required management study.
      The Bank is in compliance with the Order’s timelines for completion of
      such study and implementation by the Board of a plan to address the
      findings of such study.  As part of the capital raise, the
      Company and Bank received regulatory approval to add as a director of both
      the Bank and Company one of the principals of the investor in the
      transaction that owns approximately 14.4% of the outstanding voting shares
      of the Company.  The addition of a director to the Company’s
      Board of Directors required an amendment to the Company’s bylaws to
      increase the range of the size of the board.  The Company’s
      shareholders approved such an amendment at the June 10, 2010 Shareholder
      Meeting and the director was added to the Company’s Board effective June
      23, 2010.
 
 ·
              Under
      the Order the Bank’s Board of Directors must also increase its
      participation in the affairs of the Bank, assuming full responsibility for
      the approval of sound policies and objectives and for the supervision of
      all the Bank’s activities.  The Board of Directors believes it
      has always provided appropriate oversight of the Bank, but has recently
      taken steps to reevaluate such oversight and enhance where appropriate the
      frequency and duration and the scope and depth of matters covered at its
      Board meetings in response to the current economic environment and
      concerns raised in the ROE.  In direct response to the ROE, a
      new joint regulatory compliance committee was formed at both the Bank and
      Company levels to oversee the Bank’s and Company’s response to all
      regulatory matters, including the Order and the Written Agreement,
      discussed below.  Detailed tracking of the Order’s requirements,
      and the Bank’s progress in responding thereto, is reviewed and reported at
      all such committee meetings, with regular reports then being provided by
      the committee to the full Board.  Further, and prior to the
      issuance of the Order, the Board directed its Chairman, Michael Morris, to
      significantly increase his direct oversight of Management and involvement
      in Bank and Company affairs to ensure an appropriate response at both the
      Bank and Company to the concerns raised in the recent examination of the
      Bank.
 
 ·
              The
      Order further requires the Bank to increase its Allowance for Loan Losses
      (“ALLL”), as of the date of the ROE, by $3.5 million and to review and
      revise its ALLL methodology.  The Bank subsequently made
      provisions of approximately $19.3 million in the third and fourth quarters
      of 2009 and increased the ALLL by a net $4.2 million in the first quarter
      of 2010.  The Bank has revised its Policy for determining the
      adequacy of the ALLL to include an assessment of market conditions and
      other qualitative factors.  The Bank’s Policy otherwise
      continues to provide for a comprehensive determination of the adequacy of
      its ALLL which is to be reviewed promptly and regularly at least once each
      calendar quarter and be properly reported, and any deficiency in the
      allowance must be remedied in the calendar quarter it is discovered, by a
      charge to current operating earnings.  As of the date of this
      report the Bank is in compliance with this provision of the
      Order.
 
 ·
              With
      respect to classified assets as of the date of the ROE, the Order also
      requires the Bank to charge-off or collect all assets classified as “Loss”
      and one-half of the assets classified as “Doubtful,” and within 180 days
      of the Order to reduce its level of assets classified as “Substandard” to
      no more than the greater of $50.0 million or 50% of Tier 1 capital plus
      the ALLL.  As of December 31, 2009, the Bank met the requirement
      to charge-off or collect all assets classified as “Loss” and one-half of
      the assets classified as “Doubtful” as of the date of the
      ROE.  At September 30, 2010, the Bank has met the requirement to
      reduce assets classified as “Substandard” as of the date of the ROE to no
      more than the greater of $50.0 million or 50% of Tier 1 capital plus the
      ALLL.
 
 ·
              The
      Order requires that the Bank develop or revise, adopt and implement a
      plan, which must be approved by the FDIC and DFI, to reduce the amount of
      Commercial Real Estate loans extended, particularly focusing on reducing
      loans for construction and land development. At September 30, 2010, the
      Bank has reduced its concentrations for Commercial Real Estate and
      construction and land development to within guidelines acceptable by the
      Order. In addition, the Bank is to develop a plan for reducing the number
      of “watch list” credits to an acceptable level, and develop or revise its
      written lending and collection policies to provide more effective guidance
      and control over the Bank’s lending function.  At September 30,
      2010, the Bank has in place a plan to comply with this provision of the
      Order.
 
 ·
              The
      Order restricts the Bank from taking certain actions without the prior
      written consent of the FDIC and the DFI, including paying cash dividends,
      and from extending additional credit to certain types of borrowers. The
      Bank has not paid cash dividends since the first quarter of 2008. In
      addition, the Bank has put processes and controls in place to ensure
      extensions of credit, directly or indirectly, are not granted to those who
      are related to borrowers of loans charged-off or classified as “Loss”,
      “Substandard” or “Doubtful” in the ROE. The Bank has also acknowledged
      that neither the loan committee nor the Board of Directors will approve
      any extension to a borrower classified “Substandard” or “Doubtful” in the
      ROE without first collecting all past due interest in
  cash.
  Heritage
Oaks Bancorp | - 28 -
  Notes to
Consolidated Financial Statements
 
 ·
              The
      Order further requires the Bank to develop or revise, adopt and implement
      a revised liquidity policy, and to adopt a contingency funding plan to
      adequately address contingency funding sources and appropriately reduce
      contingency funding reliance on off-balance sheet sources.  The
      Bank has revised its current liquidity policy and contingency funding
      plan.
 
 ·
              The
      Order also requires that the Bank prepare and submit a revised business
      plan, that is to include a comprehensive budget, and a 3 year strategic
      plan, and to further revise its investment policy.  The Bank has
      since prepared a comprehensive budget and revised the investment policy
      and is in the process of developing a revised business plan and 3 year
      strategic plan.
 
 Although
the Company believes it is in full compliance with all provisions of the Order
as of the date of this report, ultimate determination of compliance will be
determined by the FDIC and DFI in connection with their examination of the Bank
and other regulatory processes.
 
 Written
Agreement
 
 On March
4, 2010, the Company entered into a written agreement with the FRB (the “Written
Agreement”), which requires the Company to take certain measures to improve its
safety and soundness. Under the Written Agreement, the Company is required to
develop and submit for approval, a plan to maintain sufficient capital at the
Company and the Bank within 60 days of the date of the Written Agreement. The
Written Agreement further provides, among other things, that the Company shall
not: declare or pay dividends without prior approval of the FRB, take dividends
from the Bank, make any distribution of interest, principal or other sums on
subordinated debt or trust preferred securities, incur, increase, or guarantee
any debt.  The Company believes it is currently in compliance with all
requirements of the Written Agreement, including an update to its capital
plan.  The Company has updated its cash flow projections for 2010 and
has provided that information to the FRB.
 
 The
forgoing discussion of the Order and Written Agreement are qualified in their
entirety by reference to the complete text of the Order and Written Agreement,
which can be found on the Current Reports on Form 8-K filed March 10, 2010, and
March 8, 2010, respectively.
 
 Note
13.  Junior Subordinated Debentures
 
 On June
8, 2010, the Company repurchased $5.0 million in face amount trust preferred
securities issued by Heritage Oaks Capital Trust III, and the related $5.2
million junior subordinated debentures issued by the Company. The
repurchase resulted in a pre-tax gain of approximately $1.7 million, recognized
during the three months ended June 30, 2010. The repurchase was made pursuant to
the non-objection of the Federal Reserve Bank of San Francisco and approval of
the United States Treasury Department.
 
 In the
second quarter of 2010 the Company elected to defer interest payments on $8.2
million junior subordinated debentures to comply with the terms of the Written
Agreement entered into between the Company and the Federal Reserve Bank of San
Francisco.  As a result the Company has accrued for but has not paid
approximately $89 thousand in interest payments on these debentures, as of
September 30, 2010, for the second and third quarter 2010 payments due on these
debentures. For more information concerning the Written Agreement, please refer
to Note 12. Regulatory Order and Written Agreement of these consolidated
financial statements.  For such time as the Company continues to the
deferral of interest, it will be prevented from, among other things, paying
dividends on its preferred and common stock.
 
 Note
14.  Reclassifications
 
 Certain
amounts in the 2009 financial statements have been reclassified to conform to
the 2010 presentation.
  Heritage
Oaks Bancorp | - 29 -
  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, including the continuing downturn in the California real
estate market, and the response of the federal and state government and our
regulators thereto, general economic 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 impact of the recent capital raise
to support the Company’s business, as well as economic, political and global
changes arising from the war on terrorism, increased profitability, continued
growth, the Company’s beliefs as to the adequacy of its existing and anticipated
allowance for loan losses, beliefs and expectations about, and requirements to
comply with the terms of Consent Order and Written Agreement issued by
regulatory authorities having oversight of the Company’s and Bank’s operations,
and financial policies of the United States government. (Refer to the Company’s
December 31, 2009 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.
  Heritage
Oaks Bancorp | - 30 -
  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 nine month periods ending September 30,
2010 and 2009.  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.  In June 2010 the Company re-purchased all
the outstanding securities related to Trust III and plans to dissolve Trust III
in the fourth quarter of 2010.
 
 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 are 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.
  Heritage
Oaks Bancorp | - 31 -
  Management’s
Discussion and Analysis
 Executive
Summary
 
 For the
three and nine months ended September 30, 2010, the Company reported a net loss
applicable to common shareholders of approximately $11.3 million and $22.6
million, respectively.  In the same periods ended a year earlier, the
Company reported a net loss applicable to common shareholders of approximately
$5.6 million and $4.2 million, respectively.  Net loss per diluted
common share was $0.45 for the third quarter of 2010, compared to net loss of
$0.73 per diluted common share in the same period ended a year
earlier.  For the first nine months of 2010, the net loss per diluted
common share was $1.54 compared to net loss per diluted common share of $0.56
for the same period ended a year earlier.
 
 Operating
results for the third quarter of 2010 were significantly impacted by a $10.5
million valuation allowance the Company recorded for a portion of its deferred
tax assets.  Please see Note 5. Deferred Tax Assets, of the
conslolidated financial statements, filed on this Form 10-Q for additional
information related to the valuation allowance established for deferred tax
assets.  Exclusive of this charge, operating results for the third
quarter of 2010, as outlined below, showed significant improvement when compared
to prior year results, as the Company experienced measured improvement in asset
quality.  However, the results for the first nine months of 2010,
exclusive of the valuation allowance established for a portion of the Company’s
deferred tax assets, when compared to the same period ended a year earlier
reflect the impact of a very challenging first six months of 2010, resulting in
higher year over year loan loss provisions.
 
 Third
quarter 2010 and year to date operating results through September 30, 2010,
exclusive of the $10.5 million valuation allowance recorded for a portion of the
Company’s deferred tax assets, were positively impacted by greater net interest
income and non-interest income as compared to the same periods a year
earlier.  Positive quarterly and year-to date impacts to net interest
income are attributable to the increased interest income generated by the
securities portfolio and reductions in the Company’s cost of interest bearing
liabilities.  Current quarter and year to date increases of
non-interest income, as compared to the same periods a year earlier are
primarily attributable to increased gains on sales of investment securities,
mortgage origination income, and a reduction in losses on sale of
OREO.  Increases in non-interest income for the first nine months
ended September 30, 2010 as compared to the same prior year period are also
significantly elevated due to the $1.7 million pre-tax gain the Company
recognized from the extinguishment of $5.0 million in junior subordinated
debentures in June 2010.
 
 The
provision for loan losses continues to have a significant negative effect on
year to date operating results through September 30, 2010; current year to date
loan loss provisions were 76.4% higher than those recorded for the same period a
year earlier.  Increased provisions for loan losses can be attributed
to downgrades in the loan portfolio and current year charge-offs related to the
continued effort to work through the troubled asset
portfolio.  However, the Company recorded 54.9% less in provision for
loan losses during the third quarter of 2010 as compared with the same quarter a
year earlier, demonstrating a deceleration in the amount of required provisions
for loan losses.  As of September 30, 2010, the allowance for loan
losses represented 3.20% of total gross loans.
 
 Non-interest
expenses decreased for the quarter ended September 30, 2010, as compared to the
third quarter of 2009, primarily as a result of decreases in OREO related
write-downs and sales costs.  This positive impact on non-interest
expense was augmented by decreases in data processing expenses and FDIC
insurance premiums, but was significantly offset by increases in salaries and
benefits, and, to a lesser extent, increases in occupancy
costs.  Non-interest expense for the nine months ended September 30,
2010 increased as compared to the same period ended a year earlier primarily due
to increases in salaries and benefits, FDIC insurance premiums and occupancy
costs; all offset partially by decreases in OREO related write-downs and sales
costs.
 
 Liquidity
continued to remain strong during the third quarter of 2010.  The
Company reported a liquidity ratio, the ratio of liquid assets not pledged for
collateral and other purposes to deposits and other liabilities, of 31.89% at
September 30, 2010, compared to 20.50% and 19.65% reported at December 31, 2009,
and September 30, 2009, respectively.  The proceeds from the March
2010 private placement, a $20.2 million or 2.6% year to date increase in total
deposits, in conjunction with reduced loan demand, contributed significantly to
the rise in on-balance sheet liquidity.
 
 The
following provides a summary of operating results for the three and nine month
periods ended September 30, 2010 and 2009:
  Heritage
Oaks Bancorp | - 32 -
  Management’s
Discussion and Analysis
 
 ·
              For
      the three and nine months ended September 30, 2010 interest income totaled
      approximately $12.7 million and $38.3 million.  When compared to
      the same three and nine month periods ended a year earlier, this
      represents increases of approximately $0.8 million and $2.3 million,
      respectively.  The increase in interest income was primarily
      driven by an increase in the average balance of the Company’s investment
      portfolio which increased by $108.7 million and $93.2 million,
      respectively, for the three and nine months ended September 30, 2010, as
      compared to the same periods ended a year earlier.  Increases
      within this category can be attributed in large part to the investment of
      excess liquidity stemming from significant year over year deposit growth
      as well as funds received in the Company’s March 2010 private
      placement.  Increases in interest income from the investment
      portfolio were augmented by increases in interest income from the loan
      portfolio, despite a $16.8 million decrease in average loan balances, for
      the three months ended September 30, 2010 as compared to the same period
      ended a year earlier.  This was primarily a result of a decrease
      of interest reversals on loans transferred to non-accrual status during
      the quarter ended September 30, 2010 as compared to the third quarter of
      2009.  Interest income from loans also increased for the nine
      months ended September 30, 2010 as compared to the same period ended a
      year earlier due to the positive impact of an increase in average loans of
      $12.4 million, which was partially offset by the negative impact of higher
      levels of forgone interest.
 
 ·
              For
      the three and nine months ended September 30, 2010, interest expense
      totaled approximately $1.9 million and $6.4 million,
      respectively.  When compared to the same three and nine month
      periods ended a year earlier, this represents a decrease in interest
      expense of approximately $0.7 million and $0.9 million,
      respectively.  Management’s continued focus on decreasing
      funding costs contributed significantly to the year over year declines
      within this category.  The cost of interest bearing deposits
      declined 60 and 39 basis points for the three and nine month periods ended
      September 30, 2010 when compared to that reported for the same three and
      nine month periods ended a year
earlier.
 
 ·
              Net
      interest income for the three and nine months ended September 30, 2010
      totaled approximately $10.8 million and $31.9 million.  Net
      interest income increased approximately $1.6 million and $3.3 million from
      that reported during the same three and nine month periods ended a year
      earlier.  Year over year changes in net interest income can be
      attributed in large part to the items mentioned in the preceding
      paragraphs.
 
 ·
              Non-interest
      income totaled approximately $2.5 million and $7.7 million for the three
      and nine month periods ended September 30, 2010, representing an increase
      of approximately $0.9 million and $3.0 million, respectively when compared
      to the same periods ended a year earlier.  Significant items
      contributing to the increase of non-interest income for both the three and
      nine months ended September 30, 2010 as compared to the same periods ended
      a year earlier were the increases of gains on sale of investment
      securities, greater amounts of mortgage origination fee income, and
      reductions in losses on disposition of OREO, which offset decreases in
      service charges on deposit accounts.  The most significant
      component of the year to date increase in non-interest income, however,
      was the $1.7 million pre-tax gain on the extinguishment of $5.0 million in
      junior subordinated debentures during the second quarter of
      2010.
 
 ·
              Non-interest
      expense totaled approximately $9.9 million and $27.6 million for the three
      and nine months ended September 30, 2010, respectively.  These
      amounts when compared to those reported for the same periods ended a year
      earlier represent a decrease of approximately $0.4 million and an increase
      of $1.9 million, respectively.  The year over year decline for
      the third quarter of 2010 can be attributed in large part to a decrease in
      both write-downs of OREO to fair market value and the costs associated
      with maintaining such assets, and to a lesser extent, reductions in
      amortization of the core deposit intangible (“CDI”) and data processing
      charges.  Increased salaries and benefits costs accounted for
      the majority of the increase in non-interest expenses for the nine months
      of 2010, and offset a significant portion of the decrease for the three
      months ended, September 30, 2010 as compared to the same periods ended a
      year earlier.  Salaries and benefits increases on a quarterly
      and year to date basis resulted from expansion in the Company’s management
      team, increases in insurance benefit premiums, and adjustments in accrued
      compensated absences.  Other year to date increases to
      non-interest expense were driven by increases in FDIC insurance premiums
      and occupancy expenses.  For more information related to
      non-interest expenses, please see “Non-Interest Expenses” of this
      Discussion and Analysis.
 
 ·
              The
      efficiency ratio was 77.90% for the third quarter of 2010, compared to
      95.12% in the third quarter of 2009.  Year over year, the
      efficiency ratio decreased from 77.02% for the nine months ending
      September 30, 2009 to 74.45% for the nine months ended September 30, 2010
      and was positively impacted due to an increase in net interest income
      during 2010 which more than offset increases in non-interest
      expenses.
 
 The
following provides a summary for significant year to date changes in financial
condition balances as of September 30, 2010:
 
 ·
              At
      September 30, 2010, gross loan balances were approximately $672.3 million,
      approximately $54.8 million or 7.5% lower than that reported at December
      31, 2009.  Contributing to the year to date decline in loan
      balances was the receipt of approximately $15.7 million in principal
      payments on non-accruing loans, $12.1 million in transfers to foreclosed
      collateral and $20.3 million in charge-offs. The remaining year to date
      decline in gross loans can be attributed to several large pay-downs during
      the first nine months of 2010 in conjunction with scheduled amortization
      of balances in the absence of significant new loan
      originations.  The lower volume of loan originations relative to
      historical periods can be attributed in part to lower demand for credit as
      well as the Company becoming more selective with respect to the types of
      loans it chooses to originate.  See also “Loans” under
      “Financial Condition” of this Discussion and Analysis for additional
      information regarding the Company’s loan
  portfolio.
  Heritage
Oaks Bancorp | - 33 -
  Management’s
Discussion and Analysis
 
 ·
              At
      September 30, 2010, total deposits were approximately $795.6 million,
      approximately $20.2 million or 2.6% higher than that reported at December
      31, 2009.  Deposits, exclusive of brokered deposits were
      approximately $794.8 million or $30.5 million higher than that reported at
      December 31, 2009.  Increases in core deposit balances allowed
      the Company to rely less on brokered deposits for funding.  At
      September 30, 2010 brokered deposit balances totaled approximately $0.9
      million and represented 0.1% of total deposits.  This compares
      to $11.2 million or 1.5% at December 31, 2009.  See also
      “Deposits and Borrowed Funds” under “Financial Condition” of this
      Discussion and Analysis for information regarding the Company’s deposit
      liabilities.
 
 ·
              At
      September 30, 2010, borrowings from the FHLB were $55.0 million, and
      decreased $10.0 million from that reported at December 31,
      2009.  The average rate paid on borrowings with the FHLB for the
      three and nine months ended September 30, 2010 was 0.73% and 0.64%,
      respectively.  This compares to the 0.63% and 0.81% reported for
      the same three and nine month periods ended a year
  earlier.
 
 ·
              Investment
      securities totaled approximately $202.2 million, approximately $81.0
      million greater than that reported at December 31, 2009.  The
      year to date increase in the portfolio can be attributed to purchases the
      Company made to maximize the yield on earning assets in the absence of
      significant new loan originations.  For additional information
      on the Company’s investment securities portfolio, please see “Investment
      Securities and Other Earning Assets” of this Discussion and
      Analysis.
 
 ·
              Federal
      Funds sold and interest bearing due from balances totaled approximately
      $40.4 million at September 30, 2010, representing an increase of
      approximately $19.0 million over that reported at December 31,
      2009.  Increased balances within this category are attributable
      in large part to approximately $20.2 million in deposit growth experienced
      during the first nine months of 2010 as well as proceeds the Company
      received related to its March 2010 private placement.  See also
      “Investment Securities and Other Earning Assets” of this Discussion and
      Analysis for additional information regarding Federal Funds sold and
      interest bearing due from balances.
 
 The
following provides an overview of asset quality as of September 30,
2010:
 
 ·
              At
      September 30, 2010, the balance of non-performing loans was approximately
      $26.8 million or $8.3 million and $11.4 million lower than that reported
      at June 30, 2010 and December 31, 2009, respectively.  As of
      September 30, 2010 the balance of non-performing loans as a percentage of
      total gross loans was 3.98% compared to the 5.03% and 5.26% reported as of
      June 30, 2010 and December 31, 2009, respectively.  Contributing
      to the year to date decrease in non-performing loans was the receipt of
      approximately $15.7 million in principal payments on non-accruing
      balances, transfers to foreclosed collateral totaling $12.1 million and
      charge-offs of approximately $20.3 million.  Contributing
      further to the year to date decrease in non-accruing loans was the return
      of approximately $3.7 million in balances to accruing status following the
      Company’s efforts to bring resolution to problem credits.  These
      reductions were offset by approximately $40.4 million in balances that
      transferred to non-accruing status during the first nine months of
      2010.  Please see “Non-Performing Assets” of this Discussion and
      Analysis for a more complete discussion of the loans the Company has
      placed on non-accrual status.
 
 ·
              At
      September 30, 2010, the allowance for loan losses totaled approximately
      $21.6 million, representing 3.20% of total gross loans.  This
      compares to the $14.4 million or 1.97% of total gross loans reported at
      December 31, 2009.  Provisions for loan losses during the three
      and nine months ended September 30, 2010 totaled approximately $4.4
      million and $25.7 million, respectively.  Provisions for loan
      losses declined approximately $5.4 million, and increased approximately
      $11.1 million for the three and nine month periods ended September 30,
      2010, when compared to the same respective periods ended in 2009. See also
      “Provision for Loan Losses” of this Discussion and Analysis for a more
      complete discussion regarding loan loss
  provisions.
 
 ·
              Charge-offs
      during the three and nine month periods ended September 30, 2010 totaled
      approximately $5.1 million and $20.3 million, respectively.  Net
      charge-offs during the three and nine month periods ended September 30,
      2010 totaled approximately $5.0 million and $18.5 million,
      respectively.  Net charge-offs to average gross loans were 0.71%
      and 2.58% for the three and nine month periods ended September 30, 2010,
      respectively.  This compares to 0.70% and 1.29% reported for the
      same three and nine month periods ended a year earlier.  Please
      see “Allowance for Loan Losses” of this Discussion and Analysis for
      additional information related to the
  charge-offs.
  Heritage
Oaks Bancorp | - 34 -
  Management’s
Discussion and Analysis
 
 ·
              OREO
      balances totaled approximately $9.0 million at September 30, 2010, an
      increase of approximately $8.1 million from that reported at December 31,
      2009.  As previously mentioned, the Company transferred
      approximately $12.1 million to OREO in the first nine months of
      2010.  OREO dispositions totaled approximately $3.1 million and
      write-downs of OREO totaled $0.9 million in first nine months of
      2010.
 
 Recent
Developments
 
 The Bank
is currently in the middle of an ongoing regulatory examination.  The
results of this examination are not known at the time of this
filing.  The results of this examination, when determined, may have an
impact on the financial results of the Bank and the Company.  Although
the Company believes it is in full compliance with the terms of the Order, as
discussed in Note 12 of the consolidated financial statements filed on this Form
10-Q, compliance will be determined by the FDIC and DFI in connection with their
examination of the Bank.
 
 Dividends
and Stock Repurchases
 
 During
the first nine months of 2010, the Company paid approximately $0.3 million in
dividends on its Series A Senior Preferred Stock issued to the U.S. Treasury
under the CPP.  In the second quarter of 2010 the Company was required
to defer dividend payments on its Series A Senior Preferred Stock to comply with
the terms of the Written Agreement entered into between the Company and the
Federal Reserve Bank of San Francisco.  See also Note 11. Preferred
Stock, of the consolidated financial statements filed on this form 10-Q for
additional information about dividends on the Company’s Series A Senior
Preferred Stock.  For more information concerning the Written
Agreement, please refer to Note 12. Regulatory Order and Written Agreement of
the consolidated financial statements filed on this Form 10-Q.
 
 The
Company paid no dividends on or made repurchases of its common stock during the
first nine months of 2010 or during the entire year of 2009.
  Heritage
Oaks Bancorp | - 35 -
  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)
                    
                    09/30/10
                    
                    
                    06/30/10
                    
                    
                    03/31/10
                    
                    
                    12/31/09
                    
                    
                    09/30/09
                    
                    
                    06/30/09
                    
                    
                    03/31/09
                    
                    
                    12/31/08Return
      on average assets
                    
                    
                    -4.29
                    %
                    
                    
                    -2.32
                    %
                    
                    
                    -0.56
                    %
                    
                    
                    -1.43
                    %
                    
                    
                    -2.30
                    %
                    
                    
                    0.23
                    %
                    
                    
                    0.54
                    %
                    
                    
                    -0.63
                    %Return
      on average equity
                    
                    
                    -32.20
                    %
                    
                    
                    -17.35
                    %
                    
                    
                    -5.70
                    %
                    
                    
                    -15.27
                    %
                    
                    
                    -22.54
                    %
                    
                    
                    2.20
                    %
                    
                    
                    6.04
                    %
                    
                    
                    -6.93
                    %Return
      on average common equity
                    
                    
                    -40.70
                    %
                    
                    
                    -55.46
                    %
                    
                    
                    -10.93
                    %
                    
                    
                    -22.05
                    %
                    
                    
                    -31.14
                    %
                    
                    
                    1.44
                    %
                    
                    
                    6.21
                    %
                    
                    
                    -6.93
                    %Average
      equity to average assets
                    
                    
                    13.32
                    %
                    
                    
                    13.36
                    %
                    
                    
                    9.88
                    %
                    
                    
                    9.35
                    %
                    
                    
                    10.18
                    %
                    
                    
                    10.68
                    %
                    
                    
                    8.95
                    %
                    
                    
                    9.06
                    %Average
      common equity to average assets
                    
                    
                    10.88
                    %
                    
                    
                    6.91
                    %
                    
                    
                    6.57
                    %
                    
                    
                    7.14
                    %
                    
                    
                    7.87
                    %
                    
                    
                    8.26
                    %
                    
                    
                    8.61
                    %
                    
                    
                    9.06
                    %Net
      interest margin
                    
                    
                    4.56
                    %
                    
                    
                    4.69
                    %
                    
                    
                    4.43
                    %
                    
                    
                    4.81
                    %
                    
                    
                    4.34
                    %
                    
                    
                    4.91
                    %
                    
                    
                    5.03
                    %
                    
                    
                    5.04
                    %Efficiency
      ratio*
                    
                    
                    77.90
                    %
                    
                    
                    68.86
                    %
                    
                    
                    76.88
                    %
                    
                    
                    70.84
                    %
                    
                    
                    95.12
                    %
                    
                    
                    70.02
                    %
                    
                    
                    66.71
                    %
                    
                    
                    66.43
                    %Average
      loans to average deposits
                    
                    
                    87.99
                    %
                    
                    
                    91.82
                    %
                    
                    
                    93.67
                    %
                    
                    
                    93.45
                    %
                    
                    
                    98.20
                    %
                    
                    
                    103.58
                    %
                    
                    
                    112.39
                    %
                    
                    
                    109.95
                    %Net
      (loss) / income
                    
                    $
                    (10,903
                    )
                    
                    $
                    (5,835
                    )
                    
                    $
                    (1,339
                    )
                    
                    $
                    (3,416
                    )
                    
                    $
                    (5,242
                    )
                    
                    $
                    507
                    
                    
                    $
                    1,102
                    
                    
                    $
                    (1,254
                    )Net
      (loss) / income available to common shareholders
                    
                    $
                    (11,260
                    )
                    
                    $
                    (9,644
                    )
                    
                    $
                    (1,690
                    )
                    
                    $
                    (3,767
                    )
                    
                    $
                    (5,594
                    )
                    
                    $
                    257
                    
                    
                    $
                    1,091
                    
                    
                    $
                    (1,254
                    )(Loss)
      / Earnings Per Common Share:Basic
                    
                    $
                    (0.45
                    )
                    
                    $
                    (0.86
                    )
                    
                    $
                    (0.22
                    )
                    
                    $
                    (0.48
                    )
                    
                    $
                    (0.73
                    )
                    
                    $
                    0.03
                    
                    
                    $
                    0.14
                    
                    
                    $
                    (0.16
                    )Diluted
                    
                    $
                    (0.45
                    )
                    
                    $
                    (0.86
                    )
                    
                    $
                    (0.22
                    )
                    
                    $
                    (0.48
                    )
                    
                    $
                    (0.73
                    )
                    
                    $
                    0.03
                    
                    
                    $
                    0.14
                    
                    
                    $
                    (0.16
                    )Weighted
      Average Outstanding Shares:Basic
                    
                    
                    25,004,479
                    
                    
                    
                    11,250,989
                    
                    
                    
                    7,717,194
                    
                    
                    
                    7,704,060
                    
                    
                    
                    7,699,377
                    
                    
                    
                    7,696,027
                    
                    
                    
                    7,689,317
                    
                    
                    
                    7,660,342Diluted
                    
                    
                    25,004,479
                    
                    
                    
                    11,250,989
                    
                    
                    
                    7,717,194
                    
                    
                    
                    7,704,060
                    
                    
                    
                    7,699,377
                    
                    
                    
                    7,866,962
                    
                    
                    
                    7,824,377
                    
                    
                    
                    7,660,342
 
 * 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, other real estate owned, SBA loans,
FF&E, extinguishment of debt and OTTI impairment losses.
 
 Local
Economy
 
 The
economy in the Company’s primary market area (San Luis Obispo and Santa Barbara
Counties) 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 267,000, 85,000,
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 in the local economy’s agricultural sector.  Vineyards
and cattle ranches also contribute largely to the local economy.  The
Central Coast’s leading agricultural industry is the production of wine grapes.
Vineyards in production have grown significantly over the past several years
throughout the Company’s service area.  Further, access to numerous
recreational activities and destinations 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. The economy in the Company’s primary markets of San Luis Obispo and
Santa Barbara counties has not been immune to the current downturn in national
and state economic conditions.  Weakened economic conditions have
resulted in, among other things, increased unemployment, increased vacancy
rates, and lower occupancy rates in the hospitality industry within the
Company’s primary markets.  However, the abundant tourism that has
developed over the past decade in the Company’s market area, especially in the
wine industry and coastal communities, has provided support for the local
economy in previous economic downturns and has, to some degree, provided support
in the current economic environment.
  Heritage
Oaks Bancorp | - 36 -
  Management’s
Discussion and Analysis
 
 The last
two years have proven to be challenging not only on the national level, but
within the state of California and more specifically the Company’s primary
market area.  As the real estate market and general economic
conditions have  continued to wane throughout the last two years, the
ability of borrowers to satisfy their obligations to the financial sector has
languished.  Although the Company’s primary market area has
historically witnessed a more stable level of economic activity, the weakened
state of the real estate market in conjunction with a decline in economic
activity in the Company’s primary market has negatively impacted the credit
quality of the loan portfolio over the last two years.  Recent
indications show the unemployment rate within California to be approximately
12.4%.  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 10.3% and 8.9%,
respectively.  Additionally, according to the most recent data
available to the Company in regard to hotel occupancy rates, published by Smith
Travel Research in June 2010, hotel occupancy rates showed a year over year
decline of 3.9% and 0.1% for Paso Robles/San Luis Obispo and Santa Barbara/Santa
Maria, respectively.  For the State of California, hotel occupancy
rates showed a year over year increase of 5.7%.
 
 Real
estate prices have fallen significantly in California and within the Company’s
market area from the highs seen during 2006 and 2007.  Recent
information provided by DataQuick Information Systems indicates that housing
prices in San Luis Obispo and Santa Barbara counties have declined in excess of
38% from the highs seen in 2006 and 2007.  Prices in some of the
largest cities in the Company’s market area such as: San Luis Obispo, Paso
Robles, Santa Barbara, and Santa Maria have experienced year over year price
variances of approximately -4%, -1%, 17%, and -6%, respectively as of August
2010. It should be noted that although changes in local median home prices
typically indicate home price appreciation and depreciation, price changes may
also reflect shifts in the composition of housing market activity. Therefore,
some of the variations in median home prices as of August 2010 may have been
impacted by compositional changes in housing demand. Real estate sales in the
Company’s market area have remained relatively stable, and can be attributed in
part to sales of distressed properties, and the work through of any additional
supply added to the market in recent years during the economic
downturn.
 
 Although
prices in the Company’s market area remain well below the highs witnessed in
2006 and 2007, a lack of oversupply in the Company’s market relative to other
areas of California, desirable climate, and close proximity to popular tourist
destinations, 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.
 
 Commercial
real estate prices in the Company’s primary markets have also come under some
pressure in the current economic downturn, although not to the extent witnessed
in some other areas of California.  The most current data available to
the Company indicates vacancy rates in the retail, office and manufacturing
sectors of the Company’s primary market area to be 3.0%, 6.1% and 5.4%,
respectively as of the fourth quarter of 2009.  This compares to
vacancy rates of 1.4%, 3.5% and 2.3% for the same respective categories in
2008.
 
 As
economic conditions continue to wane, and as the level of unemployment continues
to rise, conditions within the Company’s primary market may be negatively
impacted above and beyond what the Company has seen thus
far.  Additional job losses and any prolonged decline in economic
activity may further impact the borrowers to whom the Company has extended
credit, which may further impact the Company’s operating results and financial
condition.
 
 Critical
Accounting Policies
 
 The
Company’s significant accounting policies are set forth in the 2009 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
allowances 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 over the life of the related
loan.
  Heritage
Oaks Bancorp | - 37 -
  Management’s
Discussion and Analysis
 
  Loans on
which the accrual of interest has been discontinued are designated as
non-accruing loans.  The accrual of interest on loans is discontinued
when principal and/or interest is past due 90 days based on contractual terms of
the loan and/or when, in the opinion of Management, there is reasonable doubt as
to collectability unless such loans are well collateralized and in the process
of collection.  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 non-accruing 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, all remaining
principal and interest is estimated to be fully collectible, there has been at
least six months of sustained repayment performance since the loan was placed on
non-accrual and/or Management believes, based on current information, that such
loan is no longer impaired.
 
 The
Company considers a loan to be impaired when, based on current information and
events, it is probable that the Company will be unable to collect all amounts
due 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 discounted at the loan’s original
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 Company
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 that it is highly certain a loss has been
realized.
 
 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 as
of the balance sheet date.  The amount of the allowance is based on
Management's evaluation of the collectability 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
provisions for loan losses, which are 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.
 
 As
mentioned, loans are considered impaired if, based on current information and
events, it is probable that the Company will be unable to collect all amounts
due according to the contractual terms of the loan agreement.  In
certain instances the Company may work with the borrower to modify the terms of
the loan agreement or otherwise restructure the loan in a way that would allow
the borrower to continue to perform under the modified terms of the loan
agreement.  Loans such as these are considered impaired and require
the Company to measure the amount of impairment, if any, at the time the loan is
restructured.  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 less the cost to sell such 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.
  Heritage
Oaks Bancorp | - 38 -
  Management’s
Discussion and Analysis
 
  Appraisals
for Collateral Dependent Loans
 
 Once a
loan has been funded, the Company has a policy to perform an annual review of
the borrower’s financial condition and of any real estate securing the
loan.  This review includes, among other things, a physical inspection
of the real estate securing the loan, an analysis of any related rent rolls, an
analysis of all borrower and guarantor tax returns and financial
statements.  This information is used internally by the Company to
validate all covenants and the risk grade assigned to the loan.  If
during the review process the Company learns of additional information that
would suggest that the value of the collateral may be impaired from the original
underwriting of the loan, or the most recent appraisal, an additional
independent appraisal of the collateral is requested.  If based on the
updated appraisal information it is determined the value of the collateral is
impaired and the Company no longer expects to collect all previously determined
amounts related to the loan as stipulated in the loan’s original agreement, the
Company typically moves to establish a valuation allowance for such loans or
charge-off such differences.  Once a loan is deemed to be impaired
and/or the loan was downgraded to substandard status, the loan becomes the
responsibility of the Company’s Special Assets department, which provides more
diligent oversight of problem credits.  This oversight includes, among
other things, a review of all previous appraisals of collateral securing such
loans and determining in the Company’s best judgment if those appraisals still
represent the current fair value of the loan.  Additional appraisals
may be ordered at this time if deemed necessary.
 
 Securities
Available for Sale
 
 In
accordance with U.S. GAAP, 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 value 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 value 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 Company 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 2009 Annual Report, Note 1 of the consolidated financial
statements, which was filed on Form 10-K, the Company assess goodwill and other
intangible assets each year for impairment.  The Company’s assessment
at December 31, 2009, pursuant to its Goodwill Impairment Testing Policy, was
performed with the assistance of an independent third party and resulted in no
impairment.
 
 Deferred
Tax Assets
 
 Deferred
income taxes reflect the tax effect of temporary differences between the
financial statement carrying amounts and the corresponding tax basis of assets
and liabilities.  The Company uses an estimate of future earnings to
support its position that the benefit of its deferred tax assets will be
realized.  If future income should prove non-existent or less than the
amount of the deferred tax assets within the tax years to which they may be
applied, the asset may not be realized and a valuation allowance may be
established and the Company’s net income will be reduced.  The Company
performed an in depth analysis of its deferred tax assets to determine if the
current carrying value would be realized in future periods during the third
quarter of 2010.  Based on the Company’s analysis it determined that
approximately $10.5 million of its deferred tax assets did not meet the “more
likely than not” standard for realizability as of September 30,
2010.  Therefore the Company established a valuation allowance for
this portion of its deferred tax assets.  Please see Note 5. Deferred
Tax Assets of the consolidated financial statements, filed on this Form 10-Q for
additional information related to its deferred tax assets and the related
valuation allowance.
  Heritage
Oaks Bancorp | - 39 -
  Management’s
Discussion and Analysis
 
  Results
of Operations
 
 The
Company’s operating results for the three months ended September 30, 2010 when
compared to the same period ended a year earlier were significantly impacted by
higher provisions for income taxes, due to a $10.5 million valuation allowance
established for a portion of the Company’s deferred tax
assets.  Exclusive of this charge, operating results for the third
quarter of 2010 showed significant improvement due to a reduction in the
provisions for loan losses.  Provisions for loan losses during the
three months ended September 30, 2010 totaled approximately $4.4 million,
representing a decrease of approximately $5.4 million from that reported in the
same period ended a year earlier.  Provisions for loan losses made
during the first nine months of 2010 totaled approximately $25.7 million and
increased by $11.1 million when compared to the same period ended a year
earlier; therefore the Company’s operating results on a year to date basis,
remain below that experienced through September 30, 2009.  Net
charge-offs were similar for the three month periods ended September 30, 2010
and 2009, however the amount of provision recorded during the third quarter of
2009 was significantly larger than that recorded during the third quarter of
2010 due to the need to increase the allowance for loan losses as a percentage
of gross loans to an acceptable level.  Net charge-offs for 2010 on a
year to date basis were nearly double the amount recorded for the first nine
months of 2009, and when combined with increases in historical loan loss rates,
continued weakness in the local and national economy and deterioration in asset
quality, necessitated additional provisions for loan losses.  Please
see “Provision for Loan Losses” of this Discussion and Analysis for additional
information related to provision for loan losses.
 
 Forgone
interest on non-accrual loans continues to be a significant strain on interest
income on a year to date basis, though this trend is stabilizing due to a
deceleration in the volume of new non-accrual loans.  Total forgone
interest related to impaired loans, which includes (1) the initial accrued
interest reversal when a loan is transfered to non-accrual status, and (2)
interest lost prospectively for the period of time a loan is on non-accrual
status and lost interest due to restructuring terms below original note terms,
was approximately $0.7 million and $2.4 million during the three and nine months
ended September 30, 2010.
 
 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 net 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.  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,
in the last two years interest rates have fallen to unprecedented levels and as
a result a significant portion of loans in the Company’s loan portfolio are
currently at their floors.  Given that current interest rates are
considerably lower than most floors in the loan portfolio, the Company would
need to see a notable rise in interest rates before the overall yield on the
portfolio would begin to rise.  Additionally, as a result of
promotions over the last two years designed to attract lower cost core deposits,
the Company 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 Federal Funds and Prime rates during 2008 which are still in
place as of September 30, 2010.
 
 For the
three and nine months ended September 30, 2010 and 2009, the net interest margin
was 4.56%, 4.56%, 4.34%, 4.75%, respectively.  This represents an
increase of 22 and a decline of 19 basis points when compared to that reported
for the same periods ended a year earlier.  As mentioned, forgone
interest related to loans the Company placed on non-accrual and rate concessions
on TDRs negatively impacted the net interest margin in 2010, although less so in
the third quarter of 2010 as compared to the third quarter of
2009.  For the third quarter and first nine months of 2010 interest
reversals (related to loans placed on non-accrual during the period) negatively
impacted the net interest margin by approximately 8 and 6 basis
points.  Total forgone interest negatively impacted the net interest
margin by approximately 32 and 33 basis points for the third quarter and the
first nine months of 2010, respectively.  The shift in interest
earning asset mix away from higher yielding loans to lower yielding securities
has also begun to negatively impact the net interest margin which has resulted
primarily due to loan principal repayments and loan portfolio
amortization.  Average loans have decreased by $16.8 million for the
quarter ended September 30, 2010 as compared to the same period a year
earlier.  Additionally higher average balances of overnight liquidity
in the form of federal funds sold and interest bearing due from placed added
pressure on the margin as these investments yielded, on average, approximately
0.22% for the third quarter and 0.24% for the first nine months of
2010.
 
 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.
  Heritage
Oaks Bancorp | - 40 -
  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 nine months ended September 30, 2010 and 2009.  The average
balance of non-accruing loans has been included in loan totals:
 
 For the three months ending
                                    
                                    
                                    For the three months endingSeptember 30, 2010
                                    
                                    
                                    September 30, 2009Yield/
                                    
                                    
                                    Income/
                                    
                                    
                                    
                                    
                                    
                                    Yield/
                                    
                                    
                                    Income/(dollars in thousands)
                                    
                                    Balance
                                    
                                    
                                    Rate (4)
                                    
                                    
                                    Expense
                                    
                                    
                                    Balance
                                    
                                    
                                    Rate (4)
                                    
                                    
                                    ExpenseInterest Earning Assets:Investments
      with other banks
                                    
                                    $
                                    119
                                    
                                    
                                    
                                    1.41
                                    %
                                    
                                    $
                                    -
                                    
                                    
                                    $
                                    119
                                    
                                    
                                    
                                    3.33
                                    %
                                    
                                    $
                                    1Interest
      bearing due from banks
                                    
                                    
                                    32,708
                                    
                                    
                                    
                                    0.24
                                    %
                                    
                                    
                                    20
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    0.00
                                    %
                                    
                                    
                                    -Federal
      funds sold
                                    
                                    
                                    5,500
                                    
                                    
                                    
                                    0.11
                                    %
                                    
                                    
                                    1
                                    
                                    
                                    
                                    33,895
                                    
                                    
                                    
                                    0.25
                                    %
                                    
                                    
                                    21Investment
      securities taxable
                                    
                                    
                                    178,833
                                    
                                    
                                    
                                    3.29
                                    %
                                    
                                    
                                    1,483
                                    
                                    
                                    
                                    75,563
                                    
                                    
                                    
                                    4.66
                                    %
                                    
                                    
                                    888Investment
      securities non taxable
                                    
                                    
                                    28,080
                                    
                                    
                                    
                                    4.15
                                    %
                                    
                                    
                                    294
                                    
                                    
                                    
                                    22,653
                                    
                                    
                                    
                                    4.33
                                    %
                                    
                                    
                                    247Loans
      (1) (2)
                                    
                                    
                                    697,053
                                    
                                    
                                    
                                    6.21
                                    %
                                    
                                    
                                    10,908
                                    
                                    
                                    
                                    713,810
                                    
                                    
                                    
                                    5.95
                                    %
                                    
                                    
                                    10,703Total
      interest earning assets
                                    
                                    
                                    942,293
                                    
                                    
                                    
                                    5.35
                                    %
                                    
                                    
                                    12,706
                                    
                                    
                                    
                                    846,040
                                    
                                    
                                    
                                    5.56
                                    %
                                    
                                    
                                    11,860Allowance
      for possible loan losses
                                    
                                    
                                    (21,814
                                    )
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    (11,969
                                    )Other
      assets
                                    
                                    
                                    88,315
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    71,976Total
      assets
                                    
                                    $
                                    1,008,794
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    $
                                    906,047Interest
      Bearing Liabilities:Interest
      bearing demand
                                    
                                    $
                                    66,885
                                    
                                    
                                    
                                    0.27
                                    %
                                    
                                    $
                                    45
                                    
                                    
                                    $
                                    67,825
                                    
                                    
                                    
                                    0.92
                                    %
                                    
                                    $
                                    157Savings
                                    
                                    
                                    27,701
                                    
                                    
                                    
                                    0.16
                                    %
                                    
                                    
                                    11
                                    
                                    
                                    
                                    25,619
                                    
                                    
                                    
                                    0.28
                                    %
                                    
                                    
                                    18Money
      market
                                    
                                    
                                    286,435
                                    
                                    
                                    
                                    0.90
                                    %
                                    
                                    
                                    647
                                    
                                    
                                    
                                    209,634
                                    
                                    
                                    
                                    1.52
                                    %
                                    
                                    
                                    804Time
      deposits
                                    
                                    
                                    229,861
                                    
                                    
                                    
                                    1.72
                                    %
                                    
                                    
                                    996
                                    
                                    
                                    
                                    219,253
                                    
                                    
                                    
                                    2.32
                                    %
                                    
                                    
                                    1,284Brokered
      money market funds
                                    
                                    
                                    954
                                    
                                    
                                    
                                    0.83
                                    %
                                    
                                    
                                    2
                                    
                                    
                                    
                                    2,826
                                    
                                    
                                    
                                    0.70
                                    %
                                    
                                    
                                    5Brokered
      time deposits
                                    
                                    
                                    100
                                    
                                    
                                    
                                    0.00
                                    %
                                    
                                    
                                    -
                                    
                                    
                                    
                                    23,426
                                    
                                    
                                    
                                    1.46
                                    %
                                    
                                    
                                    86Total
      interest bearing deposits
                                    
                                    
                                    611,936
                                    
                                    
                                    
                                    1.10
                                    %
                                    
                                    
                                    1,701
                                    
                                    
                                    
                                    548,583
                                    
                                    
                                    
                                    1.70
                                    %
                                    
                                    
                                    2,354Federal
      Home Loan Bank borrowing
                                    
                                    
                                    63,370
                                    
                                    
                                    
                                    0.73
                                    %
                                    
                                    
                                    116
                                    
                                    
                                    
                                    65,000
                                    
                                    
                                    
                                    0.63
                                    %
                                    
                                    
                                    103Junior
      subordinated debentures
                                    
                                    
                                    8,248
                                    
                                    
                                    
                                    2.26
                                    %
                                    
                                    
                                    47
                                    
                                    
                                    
                                    13,403
                                    
                                    
                                    
                                    4.08
                                    %
                                    
                                    
                                    138Total
      borrowed funds
                                    
                                    
                                    71,618
                                    
                                    
                                    
                                    0.90
                                    %
                                    
                                    
                                    163
                                    
                                    
                                    
                                    78,403
                                    
                                    
                                    
                                    1.22
                                    %
                                    
                                    
                                    241Total
      interest bearing liabilities
                                    
                                    
                                    683,554
                                    
                                    
                                    
                                    1.08
                                    %
                                    
                                    
                                    1,864
                                    
                                    
                                    
                                    626,986
                                    
                                    
                                    
                                    1.64
                                    %
                                    
                                    
                                    2,595Non
      interest bearing demand
                                    
                                    
                                    180,284
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    178,293Total
      funding
                                    
                                    
                                    863,838
                                    
                                    
                                    
                                    0.86
                                    %
                                    
                                    
                                    1,864
                                    
                                    
                                    
                                    805,279
                                    
                                    
                                    
                                    1.28
                                    %
                                    
                                    
                                    2,595Other
      liabilities
                                    
                                    
                                    10,602
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    8,490Total
      liabilities
                                    
                                    $
                                    874,440
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    $
                                    813,769Stockholders'
      Equity:Preferred
      stock
                                    
                                    $
                                    23,253
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    $
                                    19,288Common
      stock
                                    
                                    
                                    101,162
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    48,695Additional
      paid in capital
                                    
                                    
                                    6,881
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    3,125Retained
      earnings
                                    
                                    
                                    2,728
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    23,171Valuation
      allowance investments
                                    
                                    
                                    330
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    (2,001
                                    )Total
      stockholders' equity
                                    
                                    
                                    134,354
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    92,278Total
      liabilities and stockholders' equity
                                    
                                    $
                                    1,008,794
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    $
                                    906,047Net
      interest income
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    $
                                    10,842
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    $
                                    9,265Net
      interest margin (3)
                                    
                                    
                                    
                                    
                                    
                                    
                                    4.56
                                    %
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    4.34
                                    %
 
 (1)
              Nonaccrual
      loans have been included in total
loans.
 (2)
              Loan
      fees of $138 and $229 for the three months ending September 30, 2010 and
      2009, 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.
  Heritage
Oaks Bancorp | - 41 -
  Management’s
Discussion and Analysis
 For the nine months ending
                                              
                                              
                                              For the nine months endingSeptember 30, 2010
                                              
                                              
                                              September 30, 2009Yield/
                                              
                                              
                                              Income/
                                              
                                              
                                              
                                              
                                              
                                              Yield/
                                              
                                              
                                              Income/(dollars
      in thousands)
                                              
                                              Balance
                                              
                                              
                                              Rate (4)
                                              
                                              
                                              Expense
                                              
                                              
                                              Balance
                                              
                                              
                                              Rate (4)
                                              
                                              
                                              ExpenseInterest
      Earning Assets:Investments
      with other banks
                                              
                                              $
                                              119
                                              
                                              
                                              
                                              1.12
                                              %
                                              
                                              $
                                              1
                                              
                                              
                                              $
                                              119
                                              
                                              
                                              
                                              3.37
                                              %
                                              
                                              $
                                              3Interest
      bearing due from banks
                                              
                                              
                                              41,216
                                              
                                              
                                              
                                              0.23
                                              %
                                              
                                              
                                              72
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              0.00
                                              %
                                              
                                              
                                              -Federal
      funds sold
                                              
                                              
                                              4,070
                                              
                                              
                                              
                                              0.10
                                              %
                                              
                                              
                                              3
                                              
                                              
                                              
                                              22,596
                                              
                                              
                                              
                                              0.22
                                              %
                                              
                                              
                                              38Investment
      securities taxable
                                              
                                              
                                              149,588
                                              
                                              
                                              
                                              3.57
                                              %
                                              
                                              
                                              3,989
                                              
                                              
                                              
                                              59,614
                                              
                                              
                                              
                                              4.66
                                              %
                                              
                                              
                                              2,077Investment
      securities non taxable
                                              
                                              
                                              22,956
                                              
                                              
                                              
                                              4.60
                                              %
                                              
                                              
                                              789
                                              
                                              
                                              
                                              19,763
                                              
                                              
                                              
                                              4.34
                                              %
                                              
                                              
                                              641Loans
      (1) (2)
                                              
                                              
                                              717,571
                                              
                                              
                                              
                                              6.24
                                              %
                                              
                                              
                                              33,478
                                              
                                              
                                              
                                              705,187
                                              
                                              
                                              
                                              6.31
                                              %
                                              
                                              
                                              33,266Total
      interest earning assets
                                              
                                              
                                              935,520
                                              
                                              
                                              
                                              5.48
                                              %
                                              
                                              
                                              38,332
                                              
                                              
                                              
                                              807,279
                                              
                                              
                                              
                                              5.97
                                              %
                                              
                                              
                                              36,025Allowance
      for possible loan losses
                                              
                                              
                                              (20,362
                                              )
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              (10,909
                                              )Other
      assets
                                              
                                              
                                              79,515
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              70,288Total
      assets
                                              
                                              $
                                              994,673
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              $
                                              866,658Interest
      Bearing Liabilities:Interest
      bearing demand
                                              
                                              $
                                              72,987
                                              
                                              
                                              
                                              0.58
                                              %
                                              
                                              $
                                              315
                                              
                                              
                                              $
                                              64,524
                                              
                                              
                                              
                                              0.72
                                              %
                                              
                                              $
                                              347Savings
                                              
                                              
                                              27,659
                                              
                                              
                                              
                                              0.27
                                              %
                                              
                                              
                                              55
                                              
                                              
                                              
                                              23,849
                                              
                                              
                                              
                                              0.21
                                              %
                                              
                                              
                                              38Money
      market
                                              
                                              
                                              276,969
                                              
                                              
                                              
                                              1.07
                                              %
                                              
                                              
                                              2,214
                                              
                                              
                                              
                                              186,921
                                              
                                              
                                              
                                              1.51
                                              %
                                              
                                              
                                              2,118Time
      deposits
                                              
                                              
                                              229,917
                                              
                                              
                                              
                                              1.89
                                              %
                                              
                                              
                                              3,246
                                              
                                              
                                              
                                              182,771
                                              
                                              
                                              
                                              2.49
                                              %
                                              
                                              
                                              3,400Brokered
      money market funds
                                              
                                              
                                              985
                                              
                                              
                                              
                                              0.68
                                              %
                                              
                                              
                                              5
                                              
                                              
                                              
                                              25,387
                                              
                                              
                                              
                                              0.72
                                              %
                                              
                                              
                                              137Brokered
      time deposits
                                              
                                              
                                              2,548
                                              
                                              
                                              
                                              1.84
                                              %
                                              
                                              
                                              35
                                              
                                              
                                              
                                              29,886
                                              
                                              
                                              
                                              1.67
                                              %
                                              
                                              
                                              373Total
      interest bearing deposits
                                              
                                              
                                              611,065
                                              
                                              
                                              
                                              1.28
                                              %
                                              
                                              
                                              5,870
                                              
                                              
                                              
                                              513,338
                                              
                                              
                                              
                                              1.67
                                              %
                                              
                                              
                                              6,413Federal
      funds purchased
                                              
                                              
                                              -
                                              
                                              
                                              
                                              0.00
                                              %
                                              
                                              
                                              -
                                              
                                              
                                              
                                              251
                                              
                                              
                                              
                                              1.07
                                              %
                                              
                                              
                                              2Securities
      sold under agreement to repurchase
                                              
                                              
                                              -
                                              
                                              
                                              
                                              0.00
                                              %
                                              
                                              
                                              -
                                              
                                              
                                              
                                              870
                                              
                                              
                                              
                                              0.15
                                              %
                                              
                                              
                                              1Other
      secured borrowing
                                              
                                              
                                              595
                                              
                                              
                                              
                                              4.94
                                              %
                                              
                                              
                                              22
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              0.00
                                              %
                                              
                                              
                                              -Federal
      Home Loan Bank borrowing
                                              
                                              
                                              64,451
                                              
                                              
                                              
                                              0.64
                                              %
                                              
                                              
                                              308
                                              
                                              
                                              
                                              80,982
                                              
                                              
                                              
                                              0.81
                                              %
                                              
                                              
                                              492Junior
      subordinated debentures
                                              
                                              
                                              11,231
                                              
                                              
                                              
                                              2.42
                                              %
                                              
                                              
                                              203
                                              
                                              
                                              
                                              13,403
                                              
                                              
                                              
                                              4.42
                                              %
                                              
                                              
                                              443Total
      borrowed funds
                                              
                                              
                                              76,277
                                              
                                              
                                              
                                              0.93
                                              %
                                              
                                              
                                              533
                                              
                                              
                                              
                                              95,506
                                              
                                              
                                              
                                              1.31
                                              %
                                              
                                              
                                              938Total
      interest bearing liabilities
                                              
                                              
                                              687,342
                                              
                                              
                                              
                                              1.25
                                              %
                                              
                                              
                                              6,403
                                              
                                              
                                              
                                              608,844
                                              
                                              
                                              
                                              1.61
                                              %
                                              
                                              
                                              7,351Non
      interest bearing demand
                                              
                                              
                                              176,401
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              162,830Total
      funding
                                              
                                              
                                              863,743
                                              
                                              
                                              
                                              0.99
                                              %
                                              
                                              
                                              6,403
                                              
                                              
                                              
                                              771,674
                                              
                                              
                                              
                                              1.27
                                              %
                                              
                                              
                                              7,351Other
      liabilities
                                              
                                              
                                              9,265
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              8,650Total
      liabilities
                                              
                                              $
                                              873,008
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              $
                                              780,324Stockholders'
      Equity:Preferred
      stock
                                              
                                              $
                                              39,325
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              $
                                              13,741Common
      stock
                                              
                                              
                                              69,499
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              48,673Additional
      paid in capital
                                              
                                              
                                              4,778
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              2,504Retained
      earnings
                                              
                                              
                                              8,159
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              23,166Valuation
      allowance investments
                                              
                                              
                                              (96
                                              )
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              (1,750
                                              )Total
      stockholders' equity
                                              
                                              
                                              121,665
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              86,334Total
      liabilities and stockholders' equity
                                              
                                              $
                                              994,673
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              $
                                              866,658Net
      interest income
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              $
                                              31,929
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              $
                                              28,674Net
      interest margin (3)
                                              
                                              
                                              
                                              
                                              
                                              
                                              4.56
                                              %
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              
                                              4.75
                                              %
 
 (1)
              Nonaccrual
      loans have been included in total
loans.
 (2)
              Loan
      fees of $496 and $711 for the nine months ending September 30, 2010 and
      2009, 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.
  Heritage
Oaks Bancorp | - 42 -


Management’s
Discussion and Analysis





The
tables below set forth changes in average interest earning assets and their
respective yields for the three and nine month periods ending September 30, 2010
compared to that reported during the same periods ended in 2009:





Average Balance
                  
                  
                  
                  
                  
                  
                  
                  
                  Average Yieldfor the three months ending
                  
                  
                  
                  
                  
                  
                  
                  
                  for the three months endingSeptember 30,
                  
                  
                  Variance
                  
                  
                  September 30,(dollars in thousands)
                  
                  2010
                  
                  
                  2009
                  
                  
                  dollar
                  
                  
                  percentage
                  
                  
                  2010
                  
                  
                  2009
                  
                  
                  VarianceInvestments
      with other banks
                  
                  $
                  119
                  
                  
                  $
                  119
                  
                  
                  $
                  -
                  
                  
                  
                  0.00
                  %
                  
                  
                  1.41
                  %
                  
                  
                  3.33
                  %
                  
                  
                  -1.92
                  %Interest
      bearing due from banks
                  
                  
                  32,708
                  
                  
                  
                  -
                  
                  
                  
                  32,708
                  
                  
                  
                  100.00
                  %
                  
                  
                  0.24
                  %
                  
                  
                  0.00
                  %
                  
                  
                  0.24
                  %Federal
      funds sold
                  
                  
                  5,500
                  
                  
                  
                  33,895
                  
                  
                  
                  (28,395
                  )
                  
                  
                  -83.77
                  %
                  
                  
                  0.11
                  %
                  
                  
                  0.25
                  %
                  
                  
                  -0.14
                  %Investment
      securities taxable
                  
                  
                  178,833
                  
                  
                  
                  75,563
                  
                  
                  
                  103,270
                  
                  
                  
                  136.67
                  %
                  
                  
                  3.29
                  %
                  
                  
                  4.66
                  %
                  
                  
                  -1.37
                  %Investment
      securities non taxable
                  
                  
                  28,080
                  
                  
                  
                  22,653
                  
                  
                  
                  5,427
                  
                  
                  
                  23.96
                  %
                  
                  
                  4.15
                  %
                  
                  
                  4.33
                  %
                  
                  
                  -0.18
                  %Loans
      (1) (2)
                  
                  
                  697,053
                  
                  
                  
                  713,810
                  
                  
                  
                  (16,757
                  )
                  
                  
                  -2.35
                  %
                  
                  
                  6.21
                  %
                  
                  
                  5.95
                  %
                  
                  
                  0.26
                  %Total
      interest earning assets
                  
                  $
                  942,293
                  
                  
                  $
                  846,040
                  
                  
                  $
                  96,253
                  
                  
                  
                  11.38
                  %
                  
                  
                  5.35
                  %
                  
                  
                  5.56
                  %
                  
                  
                  -0.21
                  %





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


(2)
            Loan
      fees of $138 and $229 for the three months ending September 30, 2010 and
      2009, respectively have been included in the interest income
      computation.





Average Balance
                  
                  
                  
                  
                  
                  
                  
                  
                  Average Yieldfor the nine months ending
                  
                  
                  
                  
                  
                  
                  
                  
                  for the nine months endingSeptember 30,
                  
                  
                  Variance
                  
                  
                  September 30,(dollars in thousands)
                  
                  2010
                  
                  
                  2009
                  
                  
                  dollar
                  
                  
                  percentage
                  
                  
                  2010
                  
                  
                  2009
                  
                  
                  VarianceInvestments
      with other banks
                  
                  $
                  119
                  
                  
                  $
                  119
                  
                  
                  $
                  -
                  
                  
                  
                  0.00
                  %
                  
                  
                  1.12
                  %
                  
                  
                  3.37
                  %
                  
                  
                  -2.25
                  %Interest
      bearing due from banks
                  
                  
                  41,216
                  
                  
                  
                  -
                  
                  
                  
                  41,216
                  
                  
                  
                  100.00
                  %
                  
                  
                  0.23
                  %
                  
                  
                  0.00
                  %
                  
                  
                  0.23
                  %Federal
      funds sold
                  
                  
                  4,070
                  
                  
                  
                  22,596
                  
                  
                  
                  (18,526
                  )
                  
                  
                  -81.99
                  %
                  
                  
                  0.10
                  %
                  
                  
                  0.22
                  %
                  
                  
                  -0.12
                  %Investment
      securities taxable
                  
                  
                  149,588
                  
                  
                  
                  59,614
                  
                  
                  
                  89,974
                  
                  
                  
                  150.93
                  %
                  
                  
                  3.57
                  %
                  
                  
                  4.66
                  %
                  
                  
                  -1.10
                  %Investment
      securities non taxable
                  
                  
                  22,956
                  
                  
                  
                  19,763
                  
                  
                  
                  3,193
                  
                  
                  
                  16.16
                  %
                  
                  
                  4.60
                  %
                  
                  
                  4.34
                  %
                  
                  
                  0.26
                  %Loans
      (1) (2)
                  
                  
                  717,571
                  
                  
                  
                  705,187
                  
                  
                  
                  12,384
                  
                  
                  
                  1.76
                  %
                  
                  
                  6.24
                  %
                  
                  
                  6.31
                  %
                  
                  
                  -0.07
                  %Total
      interest earning assets
                  
                  $
                  935,520
                  
                  
                  $
                  807,279
                  
                  
                  $
                  128,241
                  
                  
                  
                  15.89
                  %
                  
                  
                  5.48
                  %
                  
                  
                  5.97
                  %
                  
                  
                  -0.49
                  %





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


(2)
            Loan
      fees of $496 and $711 for the nine months ending September 30, 2010 and
      2009, respectively have been included in the interest income
      computation.





At
September 30, 2010, average interest earning assets were approximately $96.3
million and $128.2 million higher than that reported over the same three and
nine month periods ended a year earlier.  The primary driver behind
the increase in average interest earning assets was the growth in the Company’s
securities portfolio, which increased by $108.7 million and $93.2 million for
the quarter and nine months ended September 30, 2010.  Increases of
average balances on the securities portfolio during the third quarter of 2010
offset the $16.8 million decrease in average loan balances as compared to the
same period a year earlier.  For the nine months ended September 30,
2010 average loans contributed an additional $12.4 million and average interest
bearing due from and federal funds sold contributed an additional $22.7 million
to the increase in average interest earning assets as compared to the same
period a year earlier.





Increases
in interest bearing due from balances as well as investment securities is
primarily the result of a $42.1 million year over year increase in deposit
balances in addition to approximately $60.0 million in gross proceeds the
Company raised in its March 2010 private placement.  The yield on
earning assets for the three and nine months ended September 30, 2010 was 5.35%
and 5.48% compared to 5.56% and 5.97% for the same periods ended a year
earlier.  The year over year decline in the yield on earning assets
can be attributed to several factors including the impact of interest reversals
and forgone interest on non-accruing loans and lost interest due to TDR rate and
term concessions, as well as a significant increase in the level of lower
yielding short term investment balances.





For the
three and nine months ended September 30, 2010 the yield on the loan portfolio
was 6.21% and 6.24% or 26 basis points higher and 7 basis points lower than that
reported for the same periods ended a year earlier.  The increase in
quarterly yield on the loan portfolio can be attributed to both a $1.0 million
reduction in the quarterly amount of interest reversals on loans transferred to
non-accrual status during the third quarter of 2010, as compared to the third
quarter of 2009, and a year over year reduction in the balance of non-accrual
loans of approximately $12.6 million or 32.0%.  The decrease in loan
portfolio yield for the nine months ended September 30, 2010 can be attributed
to greater amounts of forgone interest on non-accrual loans and TDRs for the
first nine months of 2010 as compared to the same period a year
earlier.  Forgone interest for the three and nine months ended
September 30, 2010 were approximately $0.7 million and $2.4 million,
respectively and reduced the yield on the loan portfolio by 42 basis points for
both periods.


Heritage
Oaks Bancorp | - 43 -


Management’s
Discussion and Analysis





Throughout
the last twelve months the Company has sought to maintain considerable levels of
on-balance sheet liquidity through its continued focus on core deposit gathering
while operating in a challenging economic environment.  While the
Company’s liquidity position was enhanced markedly over the last twelve months
as a result of this initiative, this trend has placed some pressure on earning
asset yields as a significant portion of these funds have been invested
overnight in the form of interest bearing balances due from the Federal Reserve
and federal funds sold.  These investments yield considerably less
than what the Company might otherwise earn if those funds were invested in
loans.  As previously discussed, average loan balances, while still
showing an increase on a year over year basis of $12.4 million, actually
contracted for the three months ended September 30, 2010 by $16.8 million as
compared to the third quarter of 2009.  New loan originations have
slowed due in part to a decline in loan demand and fewer loans that meet the
Company’s underwriting criteria in the current economic
environment.  As a result, in an effort to maximize the yield on
interest earning assets in the absence of significant new loan originations, the
Company has been making selective purchases of relatively short term,
agency-backed, cash flow generating, mortgage securities over the last twelve
months.  These purchases account for the majority of the year over
year increase in the average balance of the investment portfolio and the decline
in the overall yield of taxable investment securities as they currently yield
considerably less than other investments in the portfolio.  These
relatively short term investments have allowed the Company to maximize yields on
excess liquidity while ensuring adequate cash flow to support potential loan
growth in future periods.





The
tables below set forth changes in average interest bearing liabilities and their
respective rates for the three and nine month periods ending September 30, 2010
compared to that reported during the same periods ended in 2009:





Average Balance
                      
                      
                      
                      
                      
                      
                      
                      
                      Average Ratefor the three months ending
                      
                      
                      
                      
                      
                      
                      
                      
                      for the three months endingSeptember 30,
                      
                      
                      Variance
                      
                      
                      September 30,(dollars in thousands)
                      
                      2010
                      
                      
                      2009
                      
                      
                      dollar
                      
                      
                      percentage
                      
                      
                      2010
                      
                      
                      2009
                      
                      
                      VarianceInterest
      bearing demand
                      
                      $
                      66,885
                      
                      
                      $
                      67,825
                      
                      
                      $
                      (940
                      )
                      
                      
                      -1.39
                      %
                      
                      
                      0.27
                      %
                      
                      
                      0.92
                      %
                      
                      
                      -0.65
                      %Savings
                      
                      
                      27,701
                      
                      
                      
                      25,619
                      
                      
                      
                      2,082
                      
                      
                      
                      8.13
                      %
                      
                      
                      0.16
                      %
                      
                      
                      0.28
                      %
                      
                      
                      -0.12
                      %Money
      market
                      
                      
                      286,435
                      
                      
                      
                      209,634
                      
                      
                      
                      76,801
                      
                      
                      
                      36.64
                      %
                      
                      
                      0.90
                      %
                      
                      
                      1.52
                      %
                      
                      
                      -0.62
                      %Time
      deposits
                      
                      
                      229,861
                      
                      
                      
                      219,253
                      
                      
                      
                      10,608
                      
                      
                      
                      4.84
                      %
                      
                      
                      1.72
                      %
                      
                      
                      2.32
                      %
                      
                      
                      -0.60
                      %Brokered
      money market funds
                      
                      
                      954
                      
                      
                      
                      2,826
                      
                      
                      
                      (1,872
                      )
                      
                      
                      -66.24
                      %
                      
                      
                      0.83
                      %
                      
                      
                      0.70
                      %
                      
                      
                      0.13
                      %Brokered
      time deposits
                      
                      
                      100
                      
                      
                      
                      23,426
                      
                      
                      
                      (23,326
                      )
                      
                      
                      -99.57
                      %
                      
                      
                      0.00
                      %
                      
                      
                      1.46
                      %
                      
                      
                      -1.46
                      %Federal
      Home Loan Bank borrowing
                      
                      
                      63,370
                      
                      
                      
                      65,000
                      
                      
                      
                      (1,630
                      )
                      
                      
                      -2.51
                      %
                      
                      
                      0.73
                      %
                      
                      
                      0.63
                      %
                      
                      
                      0.10
                      %Junior
      subordinated debentures
                      
                      
                      8,248
                      
                      
                      
                      13,403
                      
                      
                      
                      (5,155
                      )
                      
                      
                      -38.46
                      %
                      
                      
                      2.26
                      %
                      
                      
                      4.08
                      %
                      
                      
                      -1.82
                      %Total
      interest bearing liabilities
                      
                      $
                      683,554
                      
                      
                      $
                      626,986
                      
                      
                      $
                      56,568
                      
                      
                      
                      9.02
                      %
                      
                      
                      1.08
                      %
                      
                      
                      1.64
                      %
                      
                      
                      -0.56
                      %




Average Balance
                    
                    
                    
                    
                    
                    
                    
                    
                    Average Ratefor the nine months ending
                    
                    
                    
                    
                    
                    
                    
                    
                    for the nine months endingSeptember 30,
                    
                    
                    Variance
                    
                    
                    September 30,(dollars in thousands)
                    
                    2010
                    
                    
                    2009
                    
                    
                    dollar
                    
                    
                    percentage
                    
                    
                    2010
                    
                    
                    2009
                    
                    
                    VarianceInterest bearing demand
                    
                    $
                    72,987
                    
                    
                    $
                    64,524
                    
                    
                    $
                    8,463
                    
                    
                    
                    13.12
                    %
                    
                    
                    0.58
                    %
                    
                    
                    0.72
                    %
                    
                    
                    -0.14
                    %Savings
                    
                    
                    27,659
                    
                    
                    
                    23,849
                    
                    
                    
                    3,810
                    
                    
                    
                    15.98
                    %
                    
                    
                    0.27
                    %
                    
                    
                    0.21
                    %
                    
                    
                    0.06
                    %Money
      market
                    
                    
                    276,969
                    
                    
                    
                    186,921
                    
                    
                    
                    90,048
                    
                    
                    
                    48.17
                    %
                    
                    
                    1.07
                    %
                    
                    
                    1.51
                    %
                    
                    
                    -0.44
                    %Time
      deposits
                    
                    
                    229,917
                    
                    
                    
                    182,771
                    
                    
                    
                    47,146
                    
                    
                    
                    25.80
                    %
                    
                    
                    1.89
                    %
                    
                    
                    2.49
                    %
                    
                    
                    -0.60
                    %Brokered
      money market funds
                    
                    
                    985
                    
                    
                    
                    25,387
                    
                    
                    
                    (24,402
                    )
                    
                    
                    -96.12
                    %
                    
                    
                    0.68
                    %
                    
                    
                    0.72
                    %
                    
                    
                    -0.04
                    %Brokered
      time deposits
                    
                    
                    2,548
                    
                    
                    
                    29,886
                    
                    
                    
                    (27,338
                    )
                    
                    
                    -91.47
                    %
                    
                    
                    1.84
                    %
                    
                    
                    1.67
                    %
                    
                    
                    0.17
                    %Federal
      funds purchased
                    
                    
                    -
                    
                    
                    
                    251
                    
                    
                    
                    (251
                    )
                    
                    
                    -100.00
                    %
                    
                    
                    0.00
                    %
                    
                    
                    1.07
                    %
                    
                    
                    -1.07
                    %Securities
      sold under repurchase agreements
                    
                    
                    -
                    
                    
                    
                    870
                    
                    
                    
                    (870
                    )
                    
                    
                    -100.00
                    %
                    
                    
                    0.00
                    %
                    
                    
                    0.15
                    %
                    
                    
                    -0.15
                    %Other
      secured borrowing
                    
                    
                    595
                    
                    
                    
                    -
                    
                    
                    
                    595
                    
                    
                    
                    100.00
                    %
                    
                    
                    4.94
                    %
                    
                    
                    0.00
                    %
                    
                    
                    4.94
                    %Federal
      Home Loan Bank borrowing
                    
                    
                    64,451
                    
                    
                    
                    80,982
                    
                    
                    
                    (16,531
                    )
                    
                    
                    -20.41
                    %
                    
                    
                    0.64
                    %
                    
                    
                    0.81
                    %
                    
                    
                    -0.17
                    %Junior
      subordinated debentures
                    
                    
                    11,231
                    
                    
                    
                    13,403
                    
                    
                    
                    (2,172
                    )
                    
                    
                    -16.21
                    %
                    
                    
                    2.42
                    %
                    
                    
                    4.42
                    %
                    
                    
                    -2.00
                    %Total
      interest bearing liabilities
                    
                    $
                    687,342
                    
                    
                    $
                    608,844
                    
                    
                    $
                    78,498
                    
                    
                    
                    12.89
                    %
                    
                    
                    1.25
                    %
                    
                    
                    1.61
                    %
                    
                    
                    -0.36
                    %





At
September 30, 2010, the average balance of interest bearing liabilities was
approximately $56.6 million and $78.5 million higher than that reported over the
same three and nine month periods ended a year earlier.  Year over
year increases in the average balance of interest bearing liabilities can be
attributed in large part to higher money market, time deposits as well as
interest bearing demand.  The Company attributes strong year over year
deposit growth within these categories to several factors including promotional
efforts to attract and retain core deposits.  This initiative allowed
the Company to pay-down FHLB borrowings and average brokered deposits of
approximately $26.8 million and $68.3 million for the three and nine month
periods ended September 30, 2010, respectively, thereby relying less on non-core
funding sources.


Heritage
Oaks Bancorp | - 44 -


Management’s
Discussion and Analysis





The
significant increases in floating rate deposit balances over the last year and
the ability to re-price those funds as needed, as well as year over year
increases in non-interest bearing demand deposits assisted the Company in
keeping its overall cost of funding down and mitigating the decline in interest
earning asset yields.  At September 30, 2010 approximately $447.3
million or 65.6% of the Company’s interest bearing liabilities possess a
floating rate.





For the
three and nine months ended September 30, 2010 the average rate paid on interest
bearing liabilities was 1.08% and 1.25%, respectively, down 56 and 36 basis
points from that reported for the same periods ended a year
earlier.  The year over year decline can be attributed in part to
increases in lower cost core deposit balances, the absence of higher cost
brokered time deposits and the re-pricing of money market and time
deposits.





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 nine month periods ended
September 30, 2010 over the same periods ended in 2009, 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 nine months endedSeptember 30, 2010 over 2009
                  
                  
                  September 30, 2010 over 2009(dollars in thousands)
                  
                  Volume
                  
                  
                  Rate
                  
                  
                  Total
                  
                  
                  Volume
                  
                  
                  Rate
                  
                  
                  TotalInterest
      Income:Investments
      with other banks
                  
                  $
                  -
                  
                  
                  $
                  (1
                  )
                  
                  $
                  (1
                  )
                  
                  $
                  -
                  
                  
                  $
                  (2
                  )
                  
                  $
                  (2
                  )Interest
      bearing due from Federal Reserve
                  
                  
                  20
                  
                  
                  
                  -
                  
                  
                  
                  20
                  
                  
                  
                  72
                  
                  
                  
                  -
                  
                  
                  
                  72Federal
      funds sold
                  
                  
                  (12
                  )
                  
                  
                  (8
                  )
                  
                  
                  (20
                  )
                  
                  
                  (21
                  )
                  
                  
                  (14
                  )
                  
                  
                  (35
                  )Investment
      securities taxable
                  
                  
                  919
                  
                  
                  
                  (324
                  )
                  
                  
                  595
                  
                  
                  
                  2,499
                  
                  
                  
                  (587
                  )
                  
                  
                  1,912Investment
      securities non-taxable (2)
                  
                  
                  87
                  
                  
                  
                  -
                  
                  
                  
                  87
                  
                  
                  
                  162
                  
                  
                  
                  2
                  
                  
                  
                  164Taxable
      equivalent adjustment (2)
                  
                  
                  (30
                  )
                  
                  
                  (10
                  )
                  
                  
                  (40
                  )
                  
                  
                  (55
                  )
                  
                  
                  39
                  
                  
                  
                  (16
                  )Loans
      (1)
                  
                  
                  (254
                  )
                  
                  
                  459
                  
                  
                  
                  205
                  
                  
                  
                  589
                  
                  
                  
                  (377
                  )
                  
                  
                  212Net
      increase / (decrease)
                  
                  
                  730
                  
                  
                  
                  116
                  
                  
                  
                  846
                  
                  
                  
                  3,246
                  
                  
                  
                  (939
                  )
                  
                  
                  2,307Interest
      expense:Savings,
      NOW, money market
                  
                  
                  211
                  
                  
                  
                  (487
                  )
                  
                  
                  (276
                  )
                  
                  
                  792
                  
                  
                  
                  (711
                  )
                  
                  
                  81Time
      deposits
                  
                  
                  59
                  
                  
                  
                  (347
                  )
                  
                  
                  (288
                  )
                  
                  
                  771
                  
                  
                  
                  (925
                  )
                  
                  
                  (154
                  )Brokered
      funds
                  
                  
                  (60
                  )
                  
                  
                  (29
                  )
                  
                  
                  (89
                  )
                  
                  
                  (565
                  )
                  
                  
                  95
                  
                  
                  
                  (470
                  )Federal
      funds purchased
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (1
                  )
                  
                  
                  (1
                  )
                  
                  
                  (2
                  )Other
      secured borrowings
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  22
                  
                  
                  
                  -
                  
                  
                  
                  22Securities
      sold under agreement to repurchase
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  (1
                  )
                  
                  
                  -
                  
                  
                  
                  (1
                  )Federal
      Home Loan Bank borrowing
                  
                  
                  (3
                  )
                  
                  
                  16
                  
                  
                  
                  13
                  
                  
                  
                  (90
                  )
                  
                  
                  (94
                  )
                  
                  
                  (184
                  )Long
      term debt
                  
                  
                  (42
                  )
                  
                  
                  (49
                  )
                  
                  
                  (91
                  )
                  
                  
                  (63
                  )
                  
                  
                  (177
                  )
                  
                  
                  (240
                  )Net
      increase / (decrease)
                  
                  
                  165
                  
                  
                  
                  (896
                  )
                  
                  
                  (731
                  )
                  
                  
                  865
                  
                  
                  
                  (1,813
                  )
                  
                  
                  (948
                  )Total
      net increase / (decrease)
                  
                  $
                  565
                  
                  
                  $
                  1,012
                  
                  
                  $
                  1,577
                  
                  
                  $
                  2,381
                  
                  
                  $
                  874
                  
                  
                  $
                  3,255





(1)
            Includes
      loan fees of $138 and $229 for the three months ending September 30, 2010
      and 2009 and $496 and $711 for the nine months ending September 30, 2010
      and 2009, respectively.


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


Heritage
Oaks Bancorp | - 45 -


Management’s
Discussion and Analysis





Non-Interest
Income





The
tables below set forth changes in non-interest income for the three and nine
month periods ended September 30, 2010 compared to the same periods ended in
2009:





For the three months endedSeptember 30,
                      
                      
                      Variance(dollars in thousands)
                      
                      2010
                      
                      
                      2009
                      
                      
                      dollar
                      
                      
                      percentageService
      charges on deposit accounts
                      
                      $
                      581
                      
                      
                      $
                      750
                      
                      
                      $
                      (169
                      )
                      
                      
                      -22.5
                      %ATM/Debit
      and credit card transaction/interchange fees
                      
                      
                      333
                      
                      
                      
                      253
                      
                      
                      
                      80
                      
                      
                      
                      31.6
                      %Bancard
                      
                      
                      53
                      
                      
                      
                      48
                      
                      
                      
                      5
                      
                      
                      
                      10.4
                      %Mortgage
      origination fees
                      
                      
                      631
                      
                      
                      
                      245
                      
                      
                      
                      386
                      
                      
                      
                      157.6
                      %Earnings
      on bank owned life insurance
                      
                      
                      143
                      
                      
                      
                      124
                      
                      
                      
                      19
                      
                      
                      
                      15.3
                      %Other
      commissions and fees
                      
                      
                      93
                      
                      
                      
                      92
                      
                      
                      
                      1
                      
                      
                      
                      1.1
                      %Net
      OTTI impairment losses on investment securities
                      
                      
                      (106
                      )
                      
                      
                      -
                      
                      
                      
                      (106
                      )
                      
                      
                      -100.0
                      %Gain
      on sale of investment securities
                      
                      
                      807
                      
                      
                      
                      211
                      
                      
                      
                      596
                      
                      
                      
                      282.5
                      %Loss
      on sale of OREO
                      
                      
                      (28
                      )
                      
                      
                      (200
                      )
                      
                      
                      172
                      
                      
                      
                      86.0
                      %Gain
      on sale of SBA loans
                      
                      
                      -
                      
                      
                      
                      70
                      
                      
                      
                      (70
                      )
                      
                      
                      -100.0
                      %Total
      non-interest income
                      
                      $
                      2,507
                      
                      
                      $
                      1,593
                      
                      
                      $
                      914
                      
                      
                      
                      57.4
                      %





For the nine months endedSeptember 30,
                    
                    
                    Variance(dollars in thousands)
                    
                    2010
                    
                    
                    2009
                    
                    
                    dollar
                    
                    
                    percentageService charges on deposit accounts
                    
                    $
                    1,820
                    
                    
                    $
                    2,214
                    
                    
                    $
                    (394
                    )
                    
                    
                    -17.8
                    %ATM/Debit
      and credit card transaction/interchange fees
                    
                    
                    915
                    
                    
                    
                    723
                    
                    
                    
                    192
                    
                    
                    
                    26.6
                    %Bancard
                    
                    
                    137
                    
                    
                    
                    140
                    
                    
                    
                    (3
                    )
                    
                    
                    -2.1
                    %Mortgage
      origination fees
                    
                    
                    1,432
                    
                    
                    
                    910
                    
                    
                    
                    522
                    
                    
                    
                    57.4
                    %Earnings
      on bank owned life insurance
                    
                    
                    437
                    
                    
                    
                    369
                    
                    
                    
                    68
                    
                    
                    
                    18.4
                    %Other
      commissions and fees
                    
                    
                    360
                    
                    
                    
                    325
                    
                    
                    
                    35
                    
                    
                    
                    10.8
                    %Net
      OTTI impairment losses on investment securities
                    
                    
                    (106
                    )
                    
                    
                    -
                    
                    
                    
                    (106
                    )
                    
                    
                    -100.0
                    %Gain
      on extinguishment of debt
                    
                    
                    1,700
                    
                    
                    
                    -
                    
                    
                    
                    1,700
                    
                    
                    
                    100.0
                    %Gain
      on sale of investment securities
                    
                    
                    710
                    
                    
                    
                    333
                    
                    
                    
                    377
                    
                    
                    
                    113.2
                    %Gain
      / (loss) on sale of OREO
                    
                    
                    34
                    
                    
                    
                    (331
                    )
                    
                    
                    365
                    
                    
                    
                    110.3
                    %Gain
      on sale of furniture fixtures and equipment
                    
                    
                    58
                    
                    
                    
                    -
                    
                    
                    
                    58
                    
                    
                    
                    100.0
                    %Gain
      on sale of SBA loans
                    
                    
                    209
                    
                    
                    
                    70
                    
                    
                    
                    139
                    
                    
                    
                    198.6
                    %Total
      non-interest income
                    
                    $
                    7,706
                    
                    
                    $
                    4,753
                    
                    
                    $
                    2,953
                    
                    
                    
                    62.1
                    %





Non-interest
income totaled approximately $2.5 million and $7.7 million for the three and
nine month periods ended September 30, 2010, representing an increase of
approximately $0.9 million and $3.0 million, respectively when compared to the
same periods ended a year earlier.  The drivers which contributed to
the increase of non-interest income for the three months ended September 30,
2010 as compared to the same period ended a year earlier, were an increase in
gains on sale of investment securities of $0.6 million, an increase of $0.4
million in mortgage origination fee income, and a reduction in the loss on sale
of OREO of $0.2 million.  These quarterly increases were partially
offset by decreases in service charges on deposit accounts of $0.2 million, and
by an OTTI impairment charge on a specific bond in the investment portfolio of
$0.1 million.  The most significant component of the year to date
increase in non-interest income as compared to the first nine months of 2009 was
the $1.7 million pre-tax gain on the extinguishment of $5.0 million in junior
subordinated debentures during the second quarter of 2010.  Other
significant contributors on a year to date basis included an increase of $0.5
million in mortgage origination fee income, an increase in gains on sale of
investment securities of $0.4 million, an increase in the gain on sale of OREO
of $0.4 million, and an increase of $0.2 million in ATM/Debit and credit card
transaction and interchange fees.  This year over year increases were
partially offset by decreases in service charges on deposit accounts of $0.4
million, and by an OTTI impairment charge on a specific bond in the investment
portfolio of $0.1 million.





The
Company attributes the decline in service charge income to better cash
management practices of business clients in the current economic
environment.  Higher transaction/interchange income is attributable to
greater focus on debit card usage in conjunction with additional core
relationships the Company obtained over the last twelve months.  The
Company also saw an increase in earnings on bank owned life insurance which can
be attributed to additional policies the Company purchased in the second half of
2009 for certain executive officers.





Mortgage
origination fees increased considerably during the third quarter and first nine
months of 2010 from that reported a year earlier.  This can be
attributed to a reduction in origination expenses the Company realized during
the first nine months of 2010.


Heritage
Oaks Bancorp | - 46 -


Management’s
Discussion and Analysis





The
tables below illustrate the change in the number and total dollar volume of
mortgage loans originated during the three and nine months ended September 30,
2010 when compared to the same periods ended in 2009:





For the three months ended
                                September 30,(dollars in thousands)
                              
                              2010
                              
                              
                              2009
                              
                              
                              VarianceDollar
      volume
                              
                              $
                              45,765
                              
                              
                              $
                              38,993
                              
                              
                              
                              17.4
                              %Number
      of loans
                              
                              
                              128
                              
                              
                              
                              99
                              
                              
                              
                              29.3
                              %





For the nine months ended
                                September 30,(dollars in thousands)
                              
                              2010
                              
                              
                              2009
                              
                              
                              VarianceDollar
      volume
                              
                              $
                              114,280
                              
                              
                              $
                              127,680
                              
                              
                              
                              -10.5
                              %Number
      of loans
                              
                              
                              327
                              
                              
                              
                              377
                              
                              
                              
                              -13.3
                              %





Non-Interest
Expenses





The
tables below set forth changes in non-interest expenses for the three and nine
month periods ended September 30, 2010 compared to the same periods ended in
2009:





For the three months endedSeptember 30,
                    
                    
                    Variance(dollars in thousands)
                    
                    2010
                    
                    
                    2009
                    
                    
                    dollar
                    
                    
                    percentageSalaries
      and employee benefits
                    
                    $
                    4,799
                    
                    
                    $
                    3,969
                    
                    
                    $
                    830
                    
                    
                    
                    20.9
                    %Occupancy
                    
                    
                    966
                    
                    
                    
                    843
                    
                    
                    
                    123
                    
                    
                    
                    14.6
                    %Equipment
                    
                    
                    433
                    
                    
                    
                    365
                    
                    
                    
                    68
                    
                    
                    
                    18.6
                    %Promotional
                    
                    
                    173
                    
                    
                    
                    191
                    
                    
                    
                    (18
                    )
                    
                    
                    -9.4
                    %Data
      processing
                    
                    
                    497
                    
                    
                    
                    687
                    
                    
                    
                    (190
                    )
                    
                    
                    -27.7
                    %Stationery
      and supplies
                    
                    
                    114
                    
                    
                    
                    111
                    
                    
                    
                    3
                    
                    
                    
                    2.7
                    %Regulatory
      fees
                    
                    
                    669
                    
                    
                    
                    851
                    
                    
                    
                    (182
                    )
                    
                    
                    -21.4
                    %Audit
      and tax costs
                    
                    
                    143
                    
                    
                    
                    182
                    
                    
                    
                    (39
                    )
                    
                    
                    -21.4
                    %Amortization
      of core deposit intangible
                    
                    
                    128
                    
                    
                    
                    262
                    
                    
                    
                    (134
                    )
                    
                    
                    -51.1
                    %Director
      fees
                    
                    
                    132
                    
                    
                    
                    80
                    
                    
                    
                    52
                    
                    
                    
                    65.0
                    %Communications
                    
                    
                    99
                    
                    
                    
                    76
                    
                    
                    
                    23
                    
                    
                    
                    30.3
                    %Loan
      department
                    
                    
                    943
                    
                    
                    
                    1,844
                    
                    
                    
                    (901
                    )
                    
                    
                    -48.9
                    %Other
                    
                    
                    778
                    
                    
                    
                    790
                    
                    
                    
                    (12
                    )
                    
                    
                    -1.5
                    %Total
      non interest expense
                    
                    $
                    9,874
                    
                    
                    $
                    10,251
                    
                    
                    $
                    (377
                    )
                    
                    
                    -3.7
                    %





For the nine months endedSeptember 30,
                    
                    
                    Variance(dollars in thousands)
                    
                    2010
                    
                    
                    2009
                    
                    
                    dollar
                    
                    
                    percentageSalaries
      and employee benefits
                    
                    $
                    13,528
                    
                    
                    $
                    11,517
                    
                    
                    $
                    2,011
                    
                    
                    
                    17.5
                    %Occupancy
                    
                    
                    2,840
                    
                    
                    
                    2,521
                    
                    
                    
                    319
                    
                    
                    
                    12.7
                    %Equipment
                    
                    
                    1,131
                    
                    
                    
                    1,066
                    
                    
                    
                    65
                    
                    
                    
                    6.1
                    %Promotional
                    
                    
                    525
                    
                    
                    
                    517
                    
                    
                    
                    8
                    
                    
                    
                    1.5
                    %Data
      processing
                    
                    
                    1,832
                    
                    
                    
                    2,049
                    
                    
                    
                    (217
                    )
                    
                    
                    -10.6
                    %Stationery
      and supplies
                    
                    
                    343
                    
                    
                    
                    314
                    
                    
                    
                    29
                    
                    
                    
                    9.2
                    %Regulatory
      fees
                    
                    
                    1,971
                    
                    
                    
                    1,531
                    
                    
                    
                    440
                    
                    
                    
                    28.7
                    %Audit
      and tax costs
                    
                    
                    428
                    
                    
                    
                    477
                    
                    
                    
                    (49
                    )
                    
                    
                    -10.3
                    %Amortization
      of core deposit intangible
                    
                    
                    385
                    
                    
                    
                    787
                    
                    
                    
                    (402
                    )
                    
                    
                    -51.1
                    %Director
      fees
                    
                    
                    388
                    
                    
                    
                    243
                    
                    
                    
                    145
                    
                    
                    
                    59.7
                    %Communications
                    
                    
                    260
                    
                    
                    
                    199
                    
                    
                    
                    61
                    
                    
                    
                    30.7
                    %Loan
      department
                    
                    
                    1,675
                    
                    
                    
                    2,356
                    
                    
                    
                    (681
                    )
                    
                    
                    -28.9
                    %Other
                    
                    
                    2,262
                    
                    
                    
                    2,113
                    
                    
                    
                    149
                    
                    
                    
                    7.1
                    %Total
      non interest expense
                    
                    $
                    27,568
                    
                    
                    $
                    25,690
                    
                    
                    $
                    1,878
                    
                    
                    
                    7.3
                    %


Heritage
Oaks Bancorp | - 47 -


Management’s
Discussion and Analysis





Salary
and Employee Benefits





Salaries
and employee related expenses increased approximately $0.8 million and $2.0
million during the three and nine months ended September 30, 2010 when compared
to that reported in the same periods ended a year earlier.  The
expansion of the Company’s management team in conjunction with additions to the
Company’s special assets department contributed to the year over year increase
within this category.  Salaries and benefits increases on a quarterly
and year to date basis resulted from: a) the expansion of the Company’s
executive management team; b) additional staff added to the special assets
department; c) adjustments to accrued compensation balances which resulted from
enhancements made to the Company’s reporting mechanisms, and to policy changes,
which impacted those balances; and d) increases in group insurance benefits,
which have risen 19.3% and 25.6% for the three and nine months ended September
30, 2010 as compared to the same periods a year earlier.





Occupancy
Expenses





Increases
within this category are primarily attributable to annual increases in rental
expense as well as the absence of sublease rental income associated with the
relocation of one branch office.





Promotion
Expenses





Promotional
expenses declined slightly in the third quarter of 2010 from that reported in
the same period a year ago.  The decline in the second quarter can be
attributed in part to Management’s efforts to contain costs within certain areas
of the Company. Promotional costs increased slightly during the first nine
months of 2010, primarily the result of increased costs incurred during the
first quarter associated with promotional efforts designed to attract and retain
core deposit balances.





Regulatory
Fees





For the
three and nine months ended September 30, 2010, regulatory fees totaled
approximately $0.7 million and $2.0 million, respectively.  This
represents a decrease of approximately $0.2 million and $0.4 million over that
reported for the same three and nine month periods ended in
2009.  Year over year increases within this category can be attributed
in large part to higher FDIC insurance costs, due both to a change in the
Company’s risk ratings and to increases in average deposit
balances.  The Company currently anticipates regulatory assessment
costs to remain elevated throughout 2010.





Core
Deposit Intangible (“CDI”) Amortization





Upon the
acquisition of Business First, the Company booked a CDI in the approximate
amount of $3.8 million.  The balance of this intangible is being
amortized over a six year period pursuant to a schedule provided in the initial
valuation process.  For the three and nine months ended September 30,
2010 CDI amortization was approximately $0.1 million and $0.4 million lower than
that reported for the same periods ended in 2009.  Substantially all
of the year over year variance can be attributed to CDI amortization associated
with the Business First acquisition.





Loan
Department Costs





For the
three and nine months ended September 30, 2010, loan department costs increased
approximately $0.9 million and $0.7 million from that reported in the same
periods ended a year earlier.  Decreases in loan department costs for
both the nine months and third quarter ended September 30, 2010 were primarily a
result of the decrease in both write-downs of OREO to fair market value and the
legal fees and other costs of OREO sales





Data
Processing





Data
processing charges decreased by $0.2 million for both the three and nine months
ended September 30, 2010 as compared that reported in the same periods a year
earlier.  The Company was able to renegotiate the terms of its core
processing service contract which lead to significant reductions of the contract
service fee during the third quarter of 2010.





Provision
for Income Taxes





For the
three and nine month periods ended September 30, 2010 the Company recorded an
income tax expense of approximately $10.0 million and $4.4 million,
respectively.  This compares to the $3.9 million and $3.2 million of
income tax benefit the Company recorded for the same periods ended in
2009.  The year over year variances for both the third quarter and
first nine months of 2010 can be attributed to a $10.5 million valuation
allowance the Company established in the third quarter of 2010 for a portion of
its deferred tax assets.  The Company’s effective tax rate was
1,078.7% and 32.6% for the three and nine months ended September 30,
2010.  The effective tax rate for the same periods ended a year
earlier was (42.7%) and (46.8%), respectively.


Heritage
Oaks Bancorp | - 48 -


Management’s
Discussion and Analysis





U.S. GAAP
requires that companies assess whether a valuation allowance should be
established against their deferred tax assets based on the consideration of all
available evidence using a “more likely than not” standard.  The
results of the Company’s third quarter 2010 analysis concerning the
realizability of its deferred tax assets indicated it was more likely than not
the Company would not be able to realize approximately $10.5 million of its
deferred tax assets and thus a corresponding valuation allowance was
established.  Please see Note 5. Deferred Tax Assets of the
consolidated financial statements, filed on this Form 10-Q for additional
information concerning the Company’s deferred tax assets.





The
deferred tax asset will be analyzed quarterly for changes affecting
realizability and the valuation allowance may be adjusted in future periods
accordingly.





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 is increased by provisions charged to earnings
and is reduced by charge-offs, net of recoveries.  The provision for
loan losses is based upon Management’s analysis of the adequacy of the allowance
for loan losses, which includes, among other things, an analysis of past loan
loss experience and Management’s evaluation of the loan portfolio under current
economic conditions.





The
Company 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 Company’s best
estimate of the allowance necessary to provide for probable estimable losses in
the portfolio as of the balance sheet date. In making this determination, the
Company analyzes the ultimate collectability of loans in the portfolio by
incorporating feedback provided by internal loan staff, Management’s findings
from internal loan reviews, findings from an independent semi-annual loan review
function, and information provided by examinations performed by regulatory
agencies.  The Company makes monthly evaluations as to the adequacy of
the allowance for loan losses and makes adjustments to the related provision for
loan losses accordingly.





The
Company accounts for problem loans in accordance with accounting guidance
provided under U.S. GAAP.  U.S. GAAP provides 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 loan
losses related to loans that are identified for evaluation in accordance with
accounting guidance under U.S. GAAP is based on discounted cash flows using the
loan’s historical effective interest rate stipulated in the loan agreement or
the fair value of the collateral for certain collateral dependent
loans.  When the Company determines a loan to be impaired, an analysis
is performed to determine the extent of the impairment and specific reserves may
be established for such loans, which in many cases requires the Company to make
additional provisions for loan losses in addition to any provisions required
under Management’s monthly analysis of the adequacy of the allowance, exclusive
of the impact that such impaired loans may have on the required balance of the
allowance and the related provision for loan losses.





The
allowance for loan losses is based on estimates, and ultimate losses will vary
from current estimates.  These estimates are reviewed monthly by the
Company’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 and
any resulting provision for loan losses for the three and nine months ended
September 30, 2010 is consistent with prior periods.





The
Company’s provision for loan losses was $4.4 million in the third quarter of
2010 and approximately $25.7 million for the first nine months of
2010.  This represents a decrease of $5.4 million and an increase of
approximately $11.1 million as compared to the amounts reported for the same
periods ended a year earlier.  Increased provisions for loan losses
can be attributed to: the replenishment of the allowance for loan losses related
to write-downs incurred within the Company’s commercial and industrial,
commercial real estate and land loan portfolios; to downgrades of certain large
credits; and to maintain an adequate allowance for loan losses given the current
level of historical charge-offs.  However, the Company recorded 54.9%
less in provision for loan losses during the third quarter of 2010 as compared
with the same quarter a year earlier, demonstrating a deceleration in the amount
of required provisions for loan losses.  As of September 30, 2010 the
Company’s allowance for loan losses represented 3.20% of total gross
loans.


Heritage
Oaks Bancorp | - 49 -


Management’s
Discussion and Analysis





The
Company 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 Company typically moves to downgrade such loans, resulting in
an increase in the required allowance to cover any potential
losses.  During 2009 and into the first nine months of 2010, the
Company further expanded the list of credits it has placed on the watch list in
an effort to add additional oversight and to more closely scrutinize certain
groups of loans that have experienced deterioration as a result of, among other
things, the continued weakened state of local, state and national economic
environments.  Management believes the significant economic downturn
witnessed during the last two years has had a considerable impact on the ability
of certain borrowers to satisfy their obligations to the Company, resulting in
continued watch list expansion, loan downgrades and corresponding increases in
loan loss provisions.  At September 30, 2010 the balance of loans the
Company has graded “substandard” totaled approximately $58.5 million of which
approximately $26.8 million were non-accruing.  When compared to the
$75.4 million in substandard balances as of December 31, 2009, substandard
balances declined approximately $16.9 million. The year to date decline in
substandard balances can be attributed in part to $20.3 million of charge-offs
of certain non-accruing loans, $12.1 million of transfers to OREO status as well
as credit upgrades of $3.7 million following workouts with various
borrowers.





The
Company also makes estimates as to the impact that certain economic factors will
have on various credits within the portfolio.  Negative economic
trends witnessed during 2008 and 2009 have continued in 2010 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.





Charge-offs
during the three and nine months ended September  30, 2010 totaled
approximately $5.1 million and $20.3 million, respectively.  This
represents an increase of approximately $0.1 million and $11.2 million when
compared to that reported for the same periods ended a year
earlier.  Net charge-offs to average loans were 0.71% and 2.58% for
the three and nine month periods ended September 30, 2010, compared to the 0.70%
and 1.29% reported for the same periods ended a year earlier.  During
2009 the majority of charge-offs occurred in the commercial and industrial,
agriculture, construction and land segments of the loan
portfolio.  The majority of charge-offs in the first nine months of
2010 continued in the categories of commercial and industrial as well as
construction and land loans.  Losses within these segments in
conjunction with the downgrade of certain large credits contributed further to
the additional provisions the Company made to the allowance for loan losses
during the first nine months of 2010.  Continued increases in the
level of charge-offs, elevated levels of substandard and non-performing loans in
conjunction with any further significant downturn in economic conditions in
future periods may result in further significant provisions to the allowance for
loan losses.





Looking
forward into the remainder of 2010, Management anticipates there to be continued
weakness in economic conditions on national, state and local levels compared to
historical periods.  Many economic forecasts suggest unemployment
levels to remain elevated for some time, which will undoubtedly place continued
pressure on conditions within the Company’s primary market
area.  Continued economic pressures may negatively impact the
financial condition of borrowers to whom the Company has extended credit and as
a result the Company may be required to make further significant provisions to
the allowance for loan losses during 2010.  That said, Management has
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.





Financial
Condition





At
September 30, 2010 total assets were approximately $990.5
million.  This represents an increase of approximately $45.4 million
or 4.8% over that reported at December 31, 2009.  The increase in
total assets is primarily attributable to higher balances in the investments
portfolio as well as higher interest bearing due from balances, resulting from
the receipt of approximately $60.0 million in gross proceeds from the Company’s
March 2010 private placement and a $20.2 million year to date increase in total
deposits.





At
September 30, 2010, total deposits were approximately $795.6 million or
approximately $20.2 million higher than that reported at December 31,
2009.  Net of a $10.4 million pay-down in brokered funds, total
deposits increased approximately $30.5 million.  Deposit growth was
across all categories except for interest bearing demand with the majority of
the year to date increase attributable to increases in time deposits,
non-interest bearing demand, and money market balances.


Heritage
Oaks Bancorp | - 50 -


Management’s
Discussion and Analysis





Loans





At
September 30, 2010 total gross loan balances were $673.9
million.  This represents a decline of approximately $54.8 million or
7.5% from the $728.7 million reported at December 31, 2009.  Pay-downs
in the commercial real estate, commercial and industrial and construction and
land segments in conjunction with charge-offs and transfers to foreclosed
collateral  associated with the work through of certain problem
credits, combined with lower overall loan demand, contributed to the year to
date decline in loan balances.





The
following table provides a summary of year to date variances in the loan
portfolio as of September 30, 2010:





September 30,
                  
                  
                  December 31,
                  
                  
                  Variance(dollars in thousands)
                  
                  2010
                  
                  
                  2009
                  
                  
                  dollar
                  
                  
                  percentageReal
      Estate SecuredMulti-family
      residential
                  
                  $
                  20,475
                  
                  
                  $
                  20,631
                  
                  
                  $
                  (156
                  )
                  
                  
                  -0.76
                  %Residential
      1 to 4 family
                  
                  
                  23,358
                  
                  
                  
                  25,483
                  
                  
                  
                  (2,125
                  )
                  
                  
                  -8.34
                  %Home
      equity line of credit
                  
                  
                  30,627
                  
                  
                  
                  29,780
                  
                  
                  
                  847
                  
                  
                  
                  2.84
                  %Commercial
                  
                  
                  343,753
                  
                  
                  
                  337,940
                  
                  
                  
                  5,813
                  
                  
                  
                  1.72
                  %Farmland
                  
                  
                  15,364
                  
                  
                  
                  13,079
                  
                  
                  
                  2,285
                  
                  
                  
                  17.47
                  %CommercialCommercial
      and industrial
                  
                  
                  139,672
                  
                  
                  
                  157,270
                  
                  
                  
                  (17,598
                  )
                  
                  
                  -11.19
                  %Agriculture
                  
                  
                  14,746
                  
                  
                  
                  17,698
                  
                  
                  
                  (2,952
                  )
                  
                  
                  -16.68
                  %Other
                  
                  
                  194
                  
                  
                  
                  238
                  
                  
                  
                  (44
                  )
                  
                  
                  -18.49
                  %ConstructionSingle
      family residential
                  
                  
                  8,972
                  
                  
                  
                  15,538
                  
                  
                  
                  (6,566
                  )
                  
                  
                  -42.26
                  %Single
      family residential - Spec.
                  
                  
                  2,789
                  
                  
                  
                  3,400
                  
                  
                  
                  (611
                  )
                  
                  
                  -17.97
                  %Tract
                  
                  
                  -
                  
                  
                  
                  2,215
                  
                  
                  
                  (2,215
                  )
                  
                  
                  -100.00
                  %Multi-family
                  
                  
                  1,870
                  
                  
                  
                  2,300
                  
                  
                  
                  (430
                  )
                  
                  
                  -18.70
                  %Hospitality
                  
                  
                  -
                  
                  
                  
                  14,306
                  
                  
                  
                  (14,306
                  )
                  
                  
                  -100.00
                  %Commercial
                  
                  
                  32,307
                  
                  
                  
                  27,128
                  
                  
                  
                  5,179
                  
                  
                  
                  19.09
                  %Land
                  
                  
                  32,167
                  
                  
                  
                  52,793
                  
                  
                  
                  (20,626
                  )
                  
                  
                  -39.07
                  %Installment
      loans to individuals
                  
                  
                  7,129
                  
                  
                  
                  8,327
                  
                  
                  
                  (1,198
                  )
                  
                  
                  -14.39
                  %All
      other loans (including overdrafts)
                  
                  
                  459
                  
                  
                  
                  553
                  
                  
                  
                  (94
                  )
                  
                  
                  -17.00
                  %Total
      loans, gross
                  
                  
                  673,882
                  
                  
                  
                  728,679
                  
                  
                  
                  (54,797
                  )
                  
                  
                  -7.52
                  %Deferred
      loan fees
                  
                  
                  1,605
                  
                  
                  
                  1,825
                  
                  
                  
                  (220
                  )
                  
                  
                  -12.05
                  %Reserve
      for possible loan losses
                  
                  
                  21,571
                  
                  
                  
                  14,372
                  
                  
                  
                  7,199
                  
                  
                  
                  50.09
                  %Total
      loans, net
                  
                  $
                  650,706
                  
                  
                  $
                  712,482
                  
                  
                  $
                  (61,776
                  )
                  
                  
                  -8.67
                  %Loans
      held for sale
                  
                  $
                  12,374
                  
                  
                  $
                  9,487
                  
                  
                  $
                  2,887
                  
                  
                  
                  30.43
                  %


Heritage
Oaks Bancorp | - 51 -


Management’s
Discussion and Analysis





Real
Estate Secured





The
following table provides a break-down of the real estate secured segment of the
Company’s loan portfolio as of September 30, 2010:





September 30, 2010
                    
                    
                    
                    
                    
                    Percent of
                    
                    
                    
                    
                    
                    SingleUndisbursed
                    
                    
                    Total Bank
                    
                    
                    Percent
                    
                    
                    Bank's Risk
                    
                    
                    Number
                    
                    
                    Largest(dollars in thousands)
                    
                    Balance
                    
                    
                    Commitment
                    
                    
                    Exposure
                    
                    
                    Composition
                    
                    
                    Based Capital
                    
                    
                    of Loans
                    
                    
                    LoanRetail
                    
                    $
                    39,388
                    
                    
                    $
                    2,168
                    
                    
                    $
                    41,556
                    
                    
                    
                    9.1
                    %
                    
                    
                    33.5
                    %
                    
                    
                    54
                    
                    
                    $
                    5,000Professional
                    
                    
                    74,919
                    
                    
                    
                    236
                    
                    
                    
                    75,155
                    
                    
                    
                    16.4
                    %
                    
                    
                    63.8
                    %
                    
                    
                    96
                    
                    
                    
                    10,000Hospitality
                    
                    
                    90,970
                    
                    
                    
                    220
                    
                    
                    
                    91,190
                    
                    
                    
                    19.9
                    %
                    
                    
                    77.5
                    %
                    
                    
                    47
                    
                    
                    
                    10,692Multi-family
                    
                    
                    20,475
                    
                    
                    
                    -
                    
                    
                    
                    20,475
                    
                    
                    
                    4.5
                    %
                    
                    
                    17.4
                    %
                    
                    
                    21
                    
                    
                    
                    3,128Home
      equity lines of credit
                    
                    
                    30,627
                    
                    
                    
                    20,192
                    
                    
                    
                    50,819
                    
                    
                    
                    11.1
                    %
                    
                    
                    26.1
                    %
                    
                    
                    319
                    
                    
                    
                    1,680Residential
      1 to 4 family
                    
                    
                    23,358
                    
                    
                    
                    839
                    
                    
                    
                    24,197
                    
                    
                    
                    5.3
                    %
                    
                    
                    19.9
                    %
                    
                    
                    72
                    
                    
                    
                    2,400Farmland
                    
                    
                    15,364
                    
                    
                    
                    353
                    
                    
                    
                    15,717
                    
                    
                    
                    3.4
                    %
                    
                    
                    13.1
                    %
                    
                    
                    24
                    
                    
                    
                    2,893Healthcare
      / medical
                    
                    
                    17,594
                    
                    
                    
                    59
                    
                    
                    
                    17,653
                    
                    
                    
                    3.9
                    %
                    
                    
                    15.0
                    %
                    
                    
                    31
                    
                    
                    
                    2,155Restaurants
                    
                    
                    7,013
                    
                    
                    
                    -
                    
                    
                    
                    7,013
                    
                    
                    
                    1.5
                    %
                    
                    
                    6.0
                    %
                    
                    
                    12
                    
                    
                    
                    2,541Commercial
                    
                    
                    99,301
                    
                    
                    
                    535
                    
                    
                    
                    99,836
                    
                    
                    
                    21.8
                    %
                    
                    
                    84.6
                    %
                    
                    
                    127
                    
                    
                    
                    5,000Other
                    
                    
                    14,568
                    
                    
                    
                    172
                    
                    
                    
                    14,740
                    
                    
                    
                    3.1
                    %
                    
                    
                    12.4
                    %
                    
                    
                    25
                    
                    
                    
                    2,100Total
      real estate secured
                    
                    $
                    433,577
                    
                    
                    $
                    24,774
                    
                    
                    $
                    458,351
                    
                    
                    
                    100.0
                    %
                    
                    
                    369.3
                    %
                    
                    
                    828
                    
                    
                    $
                    47,589





As of
September 30, 2010, real estate secured balances represented approximately
$433.6 million or 64.3% of total gross loans.  When compared to that
reported at December 31, 2009, this represents an increase of approximately $6.7
million or 1.6%.  The primary factor behind the year to date increase
can be attributed to the completion of several large hospitality construction
projects and their subsequent re-classification to the commercial real estate
segment.





At
September 30, 2010, real estate secured balances represented 369.3% of the
Bank’s total risk-based capital, compared to the 524.1% reported at December 31,
2009.  Total commitments as a percentage of the Bank’s total
risk-based capital were 390.3% at September 30, 2010, compared to 556.1%
reported at December 31, 2009.  The significant decline in these
ratios can be attributed to the additional capital the Company raised in a
private placement during the first six months of 2010 and subsequent down-stream
of $48.0 million to the Bank.





At
September 30, 2010, approximately $165.7 million or 38.2% 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: 5.5% to 9.0% in 2009, 4.5% to 8.0% in 2008 and 6.0%
to 7.0% in 2007.  An uptick in capitalization rates, as indicated
above, would indicate that we are seeing pressure on commercial real estate
prices within our market, primarily resulting from weakened economic
conditions.





In
September 2004, the Company 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 substantially leased.  The letter of credit was
renewed in September 2010 and will expire in September 2011.


Heritage
Oaks Bancorp | - 52 -


Management’s
Discussion and Analysis





Commercial





The
following table provides a break-down of the commercial and industrial segment
of the Company’s commercial loan portfolio as of September 30,
2010:





September 30, 2010
                    
                    
                    
                    
                    
                    Percent of
                    
                    
                    
                    
                    
                    SingleUndisbursed
                    
                    
                    Total Bank
                    
                    
                    Percent
                    
                    
                    Bank's Risk
                    
                    
                    Number
                    
                    
                    Largest(dollars in thousands)
                    
                    Balance
                    
                    
                    Commitment
                    
                    
                    Exposure
                    
                    
                    Composition
                    
                    
                    Based Capital
                    
                    
                    of Loans
                    
                    
                    LoanAgriculture
                    
                    $
                    2,212
                    
                    
                    $
                    3,465
                    
                    
                    $
                    5,677
                    
                    
                    
                    2.6
                    %
                    
                    
                    1.9
                    %
                    
                    
                    32
                    
                    
                    $
                    2,000Oil
      / Gas and Utilities
                    
                    
                    1,627
                    
                    
                    
                    1,847
                    
                    
                    
                    3,474
                    
                    
                    
                    1.6
                    %
                    
                    
                    1.4
                    %
                    
                    
                    11
                    
                    
                    
                    1,161Construction
                    
                    
                    21,655
                    
                    
                    
                    21,606
                    
                    
                    
                    43,261
                    
                    
                    
                    20.0
                    %
                    
                    
                    18.4
                    %
                    
                    
                    156
                    
                    
                    
                    5,438Manufacturing
                    
                    
                    6,562
                    
                    
                    
                    12,568
                    
                    
                    
                    19,130
                    
                    
                    
                    8.9
                    %
                    
                    
                    5.6
                    %
                    
                    
                    85
                    
                    
                    
                    1,675Wholesale
      and retail
                    
                    
                    11,957
                    
                    
                    
                    5,376
                    
                    
                    
                    17,333
                    
                    
                    
                    8.0
                    %
                    
                    
                    10.2
                    %
                    
                    
                    109
                    
                    
                    
                    1,148Transportation
      and warehousing
                    
                    
                    2,302
                    
                    
                    
                    441
                    
                    
                    
                    2,743
                    
                    
                    
                    1.3
                    %
                    
                    
                    2.0
                    %
                    
                    
                    30
                    
                    
                    
                    596Media
      & information services
                    
                    
                    7,302
                    
                    
                    
                    1,645
                    
                    
                    
                    8,947
                    
                    
                    
                    4.1
                    %
                    
                    
                    6.2
                    %
                    
                    
                    21
                    
                    
                    
                    4,500Financial
      services
                    
                    
                    7,260
                    
                    
                    
                    1,951
                    
                    
                    
                    9,211
                    
                    
                    
                    4.3
                    %
                    
                    
                    6.2
                    %
                    
                    
                    45
                    
                    
                    
                    1,500Real-estate
      / rental and leasing
                    
                    
                    15,755
                    
                    
                    
                    8,507
                    
                    
                    
                    24,262
                    
                    
                    
                    11.2
                    %
                    
                    
                    13.4
                    %
                    
                    
                    87
                    
                    
                    
                    3,500Professional
      services
                    
                    
                    18,503
                    
                    
                    
                    7,594
                    
                    
                    
                    26,097
                    
                    
                    
                    12.1
                    %
                    
                    
                    15.8
                    %
                    
                    
                    139
                    
                    
                    
                    2,000Healthcare
      / medical & social services
                    
                    
                    17,542
                    
                    
                    
                    7,525
                    
                    
                    
                    25,067
                    
                    
                    
                    11.6
                    %
                    
                    
                    14.9
                    %
                    
                    
                    109
                    
                    
                    
                    4,900Restaurants
      and hospitality
                    
                    
                    22,525
                    
                    
                    
                    2,332
                    
                    
                    
                    24,857
                    
                    
                    
                    11.5
                    %
                    
                    
                    19.2
                    %
                    
                    
                    108
                    
                    
                    
                    6,000All
      other
                    
                    
                    4,470
                    
                    
                    
                    1,453
                    
                    
                    
                    5,923
                    
                    
                    
                    2.8
                    %
                    
                    
                    3.8
                    %
                    
                    
                    156
                    
                    
                    
                    1,200Commercial
      and industrial
                    
                    $
                    139,672
                    
                    
                    $
                    76,310
                    
                    
                    $
                    215,982
                    
                    
                    
                    100.0
                    %
                    
                    
                    119.0
                    %
                    
                    
                    1,088
                    
                    
                    $
                    35,618





At
September 30, 2010, commercial and industrial loans represented approximately
$139.7 million or 20.7% of total gross loan balances.  This represents
a decline of approximately $17.6 million or 11.2%.  The year to date
decline can be attributed to several large pay-downs of various business lines
of credit as well as charge-offs totaling approximately $11.3 million during the
first nine months of 2010.





At
September 30, 2010 total commercial and industrial balances represented 119.0%
of the Bank’s total risk-based capital, compared to the 193.1% reported at
December 31, 2009.  Total commercial and industrial commitments as a
percentage of the Bank’s total risk-based capital was 183.9%, compared to the
288.7% reported at December 31, 2009. The significant decline in these ratios
can be attributed to the additional capital the Company raised in a private
placement during the first six months of 2010 and subsequent down-stream of
$48.0 million to the Bank.





Agriculture





At
September 30, 2010 agriculture balances totaled approximately $14.7 million or
2.2% of total gross loan balances, which represents an approximate $3.0 million
decline when compared to that reported at December 31, 2009.  The year
to date decline within this category can be attributed in large part to the
work-through of one problem loan during the second quarter of
2010.  The Company received approximately $1.9 million from the sale
of collateral related to this particular loan and subsequently charge-off the
remaining balance of approximately $0.9 million.  At September 30,
2010 agriculture balances represented 12.6% of the Bank’s total risk-based
capital.  This compares to 21.7% of the Bank’s total risk-based
capital as of December 31, 2009.


Heritage
Oaks Bancorp | - 53 -


Management’s
Discussion and Analysis





Construction





The
following table provides a break-down of the construction segment of the
Company’s loan portfolio as of September 30, 2010:





September 30, 2010
                    
                    
                    
                    
                    
                    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
                    
                    $
                    8,972
                    
                    
                    $
                    4,440
                    
                    
                    $
                    13,412
                    
                    
                    
                    24.7
                    %
                    
                    
                    7.6
                    %
                    
                    
                    20
                    
                    
                    $
                    3,325Single
      family residential - Spec.
                    
                    
                    2,789
                    
                    
                    
                    211
                    
                    
                    
                    3,000
                    
                    
                    
                    5.5
                    %
                    
                    
                    2.4
                    %
                    
                    
                    2
                    
                    
                    
                    1,750Tract
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    0.0
                    %
                    
                    
                    0.0
                    %
                    
                    
                    -
                    
                    
                    
                    -Multi-family
                    
                    
                    1,870
                    
                    
                    
                    -
                    
                    
                    
                    1,870
                    
                    
                    
                    3.4
                    %
                    
                    
                    1.6
                    %
                    
                    
                    2
                    
                    
                    
                    1,400Commercial
                    
                    
                    32,307
                    
                    
                    
                    3,616
                    
                    
                    
                    35,923
                    
                    
                    
                    66.4
                    %
                    
                    
                    27.5
                    %
                    
                    
                    13
                    
                    
                    
                    6,720Hospitality
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    0.0
                    %
                    
                    
                    0.0
                    %
                    
                    
                    -
                    
                    
                    
                    -Total
      construction
                    
                    $
                    45,938
                    
                    
                    $
                    8,267
                    
                    
                    $
                    54,205
                    
                    
                    
                    100.0
                    %
                    
                    
                    39.1
                    %
                    
                    
                    37
                    
                    
                    $
                    13,195





At
September 30, 2010, construction balances represented approximately $45.9
million or 6.8% of total gross loan balances, compared to $64.9 million or 8.9%
reported at December 31, 2009.  The decline in construction balances
can be attributed in large part to the re-classification of several large
hospitality construction loans to commercial real estate, following the
completion of the underlying projects. Contributing further to the year to date
decline within this category were charge-offs of approximately $1.0 million,
payments received on loans from the liquidation of underlying collateral
totaling approximately $1.6 million, transfers to OREO status totaling
approximately $0.9 million, and the absence of any new significant originations
within this segment.





At
September 30, 2010 total construction balances represented approximately 39.1%
of the Bank’s total risk-based capital.  This compares to the 79.7%
reported at December 31, 2009.  Total construction commitments
represented 46.2% of the Bank’s total risk-based capital at September 30,
2010.  This compares to the 103.8% reported at December 31,
2009.  The significant decline in these ratios can be attributed to
the additional capital the Company raised in a private placement during the
first six months of 2010 and subsequent down-stream of $48.0 million to the
Bank.





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 Company’s loan
portfolio as of September 30, 2010:





September 30, 2010
                    
                    
                    
                    
                    
                    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
                    
                    $
                    6,307
                    
                    
                    $
                    -
                    
                    
                    $
                    6,307
                    
                    
                    
                    19.3
                    %
                    
                    
                    5.4
                    %
                    
                    
                    30
                    
                    
                    $
                    1,000Single
      family residential - Spec.
                    
                    
                    1,427
                    
                    
                    
                    -
                    
                    
                    
                    1,427
                    
                    
                    
                    4.4
                    %
                    
                    
                    1.2
                    %
                    
                    
                    6
                    
                    
                    
                    617Tract
                    
                    
                    14,119
                    
                    
                    
                    -
                    
                    
                    
                    14,119
                    
                    
                    
                    43.2
                    %
                    
                    
                    12.0
                    %
                    
                    
                    7
                    
                    
                    
                    7,521Multi-family
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    0.0
                    %
                    
                    
                    0.0
                    %
                    
                    
                    -
                    
                    
                    
                    -Commercial
                    
                    
                    9,397
                    
                    
                    
                    500
                    
                    
                    
                    9,897
                    
                    
                    
                    30.3
                    %
                    
                    
                    8.0
                    %
                    
                    
                    18
                    
                    
                    
                    1,500Hospitality
                    
                    
                    917
                    
                    
                    
                    -
                    
                    
                    
                    917
                    
                    
                    
                    2.8
                    %
                    
                    
                    0.8
                    %
                    
                    
                    2
                    
                    
                    
                    644Total
      land
                    
                    $
                    32,167
                    
                    
                    $
                    500
                    
                    
                    $
                    32,667
                    
                    
                    
                    100.0
                    %
                    
                    
                    27.4
                    %
                    
                    
                    63
                    
                    
                    $
                    11,282





At
September 30, 2010, land balances represented approximately $32.2 million or
4.8% of total gross loan balances.  Land balances declined
approximately $20.6 million when compared to the $52.8 million reported at
December 31, 2009.  The year to date decline can be attributed to
several factors including: charge-offs of approximately $2.6 million, transfers
to OREO of approximately $4.7 million and payments received from the sale of
collateral of problem loans in the amount of $5.8
million.  Additionally, the largest note within this segment was
bifurcated into two separate notes in the absence of meaningful demand for tract
construction.  The re-financing of this note resulted in a new $5.4
million credit within the commercial and industrial segment and a corresponding
pay-down within the tract construction category.  Commercial and
industrial financing was made available for a rock quarry operation that
developed on the site of the project in the absence of demand for tract
construction.  Recent appraisals of the underlying collateral indicate
the loan is well secured and the borrower continues to perform under the terms
of the respective notes.


Heritage
Oaks Bancorp | - 54 -


Management’s
Discussion and Analysis





At
September 30, 2010 total land loan balances represented 27.4% of the Bank’s
total risk-based capital compared to the 64.8% reported at December 31,
2009.  Total land commitments represented approximately 27.8% of the
Bank’s total-risked based capital at September 30, 2010 compared to the 65.8%
reported at December 31, 2009. The significant decline in these ratios can
be attributed to the additional capital the Company raised in a private
placement during the first six months of 2010 and subsequent down-stream of
$48.0 million to the Bank.





Installment





At
September 30, 2010, the installment loan balances were approximately $7.1
million compared to the $8.3 million reported at December 31,
2009.  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
Company funds them. Settlement from the correspondents is typically within 30 to
45 days.  At September 30, 2010 mortgage correspondent loans (loans
held for sale) totaled approximately $12.4 million, $2.9 million greater than
that reported at December 31, 2009.





Foreign
Loans





At
September 30, 2010 the Company had no foreign loans outstanding.





Allowance
for Loan Losses





The
Company maintains an allowance for loan losses at a level considered by
Management to be adequate to provide for probable incurred losses as of the date
of the balance sheet.  The allowance is comprised of three components:
specific credit allocation, general portfolio allocation, and subjectively
determined allocation.  The allowance is increased by provisions for
loan losses charged to earnings and decreased by loan charge-offs, net of
recovered balances.





Specific
Credit Allocation





The
specific credit allocation of the allowance is determined through the
measurement of impairment on certain loans that have been identified during each
reporting period as impaired.  A loan is considered impaired when,
based on current information and events, it is probable the Company will be
unable to collect all amounts due according to the contractual terms of the loan
agreement.  The Company may also consider a loan impaired when based
on certain information and events surrounding a borrower, it is determined that
the likelihood of the Company receiving all scheduled payments, including
interest, when due is remote.  Once a loan is classified as impaired,
the Company places the loan under the supervision of its Special Assets
department.  The Special Assets department is responsible for
performing comprehensive analyses of impaired loans, including obtaining updated
financial information regarding the borrower, obtaining updated appraisals on
any collateral securing such loans and ultimately determining the extent to
which such loans are impaired.  Once the amount of impairment on
specific impaired loans has been determined, the Company typically establishes a
corresponding valuation allowance, which then becomes a component of the
Company’s specific credit allocation in the allowance for loan
losses.





General
Portfolio Allocation





For
purposes of determining the general portfolio allocation of the allowance, the
loan portfolio is segmented into several pools of loans, exclusive of balances
individually evaluated for impairment, similar to the stratification presented
in Note 3. Loans and the Allowance for Loan Losses, of the consolidated
financial statements filed on this Form 10-Q.  The loan portfolio is
then further segmented by an internal loan grading system that classifies loans
as: pass, special mention, substandard and doubtful.  Estimated loss
rates are then applied to each segment of the loan portfolio according to loan
grade to determine the amount of the general portfolio
allocation.  Estimated loss rates applied are determined through an
analysis of historical loss rates for each segment of the loan portfolio, based
on the Company’s prior experience with such loans.


Heritage
Oaks Bancorp | - 55 -




Management’s
Discussion and Analysis


Subjectively
Determined Allocation





The
subjectively determined allocation of the allowance is determined by estimates
the Company makes in regard to certain internal and external factors that may
have either a positive or negative impact on the overall credit quality of the
loan portfolio.  Certain of these factors include: local, state and
national economic and business conditions, trends in the credit quality of the
loan portfolio, existence and the effects of concentrations, the nature and
volume of the loan portfolio, the quality of loan review as well as any other
factor determined by Management to possibly have an impact on the credit quality
of the loan portfolio.





Management
periodically monitors loans in the portfolio to identify certain credits that
may be impaired and/or experiencing deterioration and as such, makes appropriate
changes in the level of the allowance when necessary.  Management
employs the use of, among other things, a watch list, loan grading system,
feedback provided by internal loan staff regarding specific credits,
Management’s findings from internal loan reviews, findings and analyses provided
from the Company’s semi-annual independent loan review function and information
provided from examinations by regulatory agencies to manage credit risk and
address any necessary changes in the required level of the allowance for loan
losses in a timely manner.





The
determination of the amount of the allowance and any corresponding increase or
decrease in the level of provisions for loan losses is based on Management’s
best estimate of the current credit quality of the loan portfolio and any
probable inherent losses as of the balance sheet date.  The nature of
the process in which Management determines the appropriate level of the
allowance involves the exercise of considerable judgment.  While
Management utilizes its best judgment and all available information in
determining the adequacy of the allowance, the ultimate adequacy of the
allowance is dependent upon a variety of factors beyond the Company’s control,
including but not limited to, the performance of the loan portfolio, changes in
current and future economic conditions and the view of regulatory agencies
regarding the level of classified assets.  Continued weakness in
economic conditions and any other factor that may adversely affect credit
quality, result in higher levels of past due and non-accruing loans, defaults,
and additional loan charge-offs, which may require additional provisions for
loan losses in future periods and a higher balance in the Company’s allowance
for loan losses.





The
allowance for loan losses increased in the third quarter of 2010 over that
reported at December 31, 2009, due to several factors including: continued
weakness in the economy, continued elevated levels in the number of and dollar
volume of non-performing and classified loans when compared to historical
periods and higher levels of charge-offs.  At September 30, 2010 the
balance of classified loans was approximately $60.2 million.  This
compares to the $75.4 million in classified loan balances reported at December
31, 2009.  Although the balance of classified loans has declined
compared to that reported at December 31, 2009, classified balances remain at
elevated levels when compared to historical periods, which has resulted in
higher required balances in the general portfolio allocation under the Company’s
methodology for determining an appropriate level for the allowance for loan
losses.  Elevated charge-offs also contributed significantly to the
higher required balances of the general portfolio allocation of the
allowance.  Additionally, continued weakened economic conditions, as
well as the continued pressure economic conditions have placed on real estate
values, resulted in higher required balances of the subjectively determined
allocation of the allowance.  As a result of the items mentioned the
Company made provisions for loan losses in the amount of $4.4 million and $25.7
million for the three and nine months ended September 30, 2010,
respectively.  This compares to provisions of approximately $9.8
million and $14.6 million during the same periods ended a year
earlier.  As a result the allowance for loan losses at September 30,
2010 was approximately $21.6 million compared to the $14.4 million reported at
December 31, 2009, an increase of approximately $7.2 million or 50.1% during the
first nine months of 2010.





Loans
charged-off during the three and nine months ended September 30, 2010 totaled
approximately $5.1 million and $20.3 million, respectively.  This
compares to charge-offs of approximately $5.0 million and $9.1 million reported
for the same periods ended a year earlier.





Comprising
the majority of charge-offs for the third quarter of 2010 was the charge-off of
three large credits in the commercial real estate, commercial and industrial
(“C&I”), and land segments of the loan portfolio.  These
charge-offs accounted for approximately $2.6 million or 50.2% of total
charge-offs during the third quarter of 2010.  Additionally,
approximately $1.4 million of C&I charge-offs can be attributed to 18 loans
in which the entire carrying value was charged-off.  The majority of
these loans represented smaller unsecured business lines of
credit.  Charge-offs in the land segment for the third quarter of 2010
can be attributed in large part to the write-down of one large credit in the
approximate amount of $1.3 million.





Year to
date, the majority of charge-offs, approximately $17.1 million or 84.1%,
occurred in the commercial real estate, C&I, and land segments of the loan
portfolio.  Year to date charge-offs within the commercial real estate
segment can be attributed to three large write-downs totaling $2.5 million,
which account for 79.8% of total year to date charge-offs within this
segment.  Approximately $4.4 million or 39.2% of year to date
charge-offs within the C&I segment can be attributed to the write-down of
two large credits.  The remainder of year to date charge-offs within
this segment can primarily be attributed to smaller lines of credit that were
placed on non-accrual and subsequently charged-off during the first nine months
of 2010.  Year to date charge-offs in the land segment can be
attributed in large part to a $1.3 million write-down on one large credit, which
occurred during the third quarter of 2010 and is referenced in the preceding
paragraph.


Heritage
Oaks Bancorp | - 56 -







Net
charge-offs to average loans for the three and nine months ended September 30,
2010 were 0.71% and 2.58%, respectively.  This compares to the 0.70%
and 1.29% reported for the same three and nine month periods ended a year
earlier.  At September 30, 2010 the allowance for loan losses
represented 3.20% of total gross loans compared to the 1.97% reported at
December 31, 2009.





As of
September 30, 2010 Management believes the allowance for loan losses was
sufficient to cover current estimable losses in the Company’s loan
portfolio.


Heritage
Oaks Bancorp | - 57 -







The
following table provides an analysis of the allowance for loan losses for the
periods indicated:





For the nine monthsended September 30,(dollars amounts in
    thousands)
                                    
                                    2010
                                    
                                    
                                    2009Balance,
      beginning of period
                                    
                                    $
                                    14,372
                                    
                                    
                                    $
                                    10,412Charge-offs:Real
      Estate SecuredMulti-family
      residential
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Residential
      1 to 4 family
                                    
                                    
                                    598
                                    
                                    
                                    
                                    304Home
      equity line of credit
                                    
                                    
                                    1
                                    
                                    
                                    
                                    -Commercial
                                    
                                    
                                    3,106
                                    
                                    
                                    
                                    41Farmland
                                    
                                    
                                    235
                                    
                                    
                                    
                                    -CommercialCommercial
      and industrial
                                    
                                    
                                    11,348
                                    
                                    
                                    
                                    1,728Agriculture
                                    
                                    
                                    1,253
                                    
                                    
                                    
                                    1,909Other
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Construction
                                    
                                    
                                    1,009
                                    
                                    
                                    
                                    2,218Land
                                    
                                    
                                    2,629
                                    
                                    
                                    
                                    2,792Installment
      loans to individuals
                                    
                                    
                                    132
                                    
                                    
                                    
                                    -All
      other loans
                                    
                                    
                                    -
                                    
                                    
                                    
                                    143Total
      charge-offs
                                    
                                    
                                    20,311
                                    
                                    
                                    
                                    9,135Recoveries:Real
      Estate SecuredMulti-family
      residential
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Residential
      1 to 4 family
                                    
                                    
                                    87
                                    
                                    
                                    
                                    9Home
      equity line of credit
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Commercial
                                    
                                    
                                    25
                                    
                                    
                                    
                                    -Farmland
                                    
                                    
                                    6
                                    
                                    
                                    
                                    -CommercialCommercial
      and industrial
                                    
                                    
                                    308
                                    
                                    
                                    
                                    4Agriculture
                                    
                                    
                                    73
                                    
                                    
                                    
                                    -Other
                                    
                                    
                                    -
                                    
                                    
                                    
                                    -Construction
                                    
                                    
                                    27
                                    
                                    
                                    
                                    16Land
                                    
                                    
                                    1,272
                                    
                                    
                                    
                                    -Installment
      loans to individuals
                                    
                                    
                                    12
                                    
                                    
                                    
                                    -All
      other loans
                                    
                                    
                                    -
                                    
                                    
                                    
                                    1Total
      recoveries
                                    
                                    
                                    1,810
                                    
                                    
                                    
                                    30Net
      charge-offs
                                    
                                    
                                    18,501
                                    
                                    
                                    
                                    9,105Provisions
      for loan losses
                                    
                                    
                                    25,700
                                    
                                    
                                    
                                    14,566Balance,
      end of period
                                    
                                    $
                                    21,571
                                    
                                    
                                    $
                                    15,873Gross
      loans, end of period
                                    
                                    $
                                    673,882
                                    
                                    
                                    $
                                    709,867Net
      charge-offs to average loans
                                    
                                    
                                    2.58
                                    %
                                    
                                    
                                    1.29
                                    %Allowance
      for loan losses to total gross loans
                                    
                                    
                                    3.20
                                    %
                                    
                                    
                                    2.24
                                    %Non-performing
      loans to allowance for loan losses
                                    
                                    
                                    124.37
                                    %
                                    
                                    
                                    250.98
                                    %


Heritage
Oaks Bancorp | - 58 -







For
reporting purposes, the Company allocates the allowance for loan losses across
product types within the loan portfolio.  However, substantially all
of the allowance is available to absorb all credit losses without restriction,
unless specific reserves have been established.  The following table
provides a summary of the allowance for loan losses and its allocation to each
major loan category of the loan portfolio as well as the percentage that each
major category of loans comprises as compared to total gross loan balances as of
the dates indicated below:





September 30,
                          
                          
                          December 31,2010
                          
                          
                          2009
                          
                          
                          2009Percent
                          
                          
                          
                          
                          
                          Percent
                          
                          
                          
                          
                          
                          PercentAmount
                          
                          
                          of Total
                          
                          
                          Amount
                          
                          
                          of Total
                          
                          
                          Amount
                          
                          
                          of Total(dollars amounts in thousands)
                          
                          Allocated
                          
                          
                          Loans
                          
                          
                          Allocated
                          
                          
                          Loans
                          
                          
                          Allocated
                          
                          
                          LoansReal
      Estate SecuredMulti-family
      residential
                          
                          $
                          453
                          
                          
                          
                          3.0
                          %
                          
                          $
                          444
                          
                          
                          
                          2.4
                          %
                          
                          $
                          119
                          
                          
                          
                          2.8
                          %Residential
      1 to 4 family
                          
                          
                          431
                          
                          
                          
                          3.5
                          %
                          
                          
                          429
                          
                          
                          
                          3.5
                          %
                          
                          
                          264
                          
                          
                          
                          3.5
                          %Home
      equity line of credit
                          
                          
                          280
                          
                          
                          
                          4.5
                          %
                          
                          
                          159
                          
                          
                          
                          4.1
                          %
                          
                          
                          179
                          
                          
                          
                          4.1
                          %Commercial
                          
                          
                          11,109
                          
                          
                          
                          51.0
                          %
                          
                          
                          5,555
                          
                          
                          
                          44.7
                          %
                          
                          
                          6,081
                          
                          
                          
                          46.5
                          %Farmland
                          
                          
                          173
                          
                          
                          
                          2.3
                          %
                          
                          
                          238
                          
                          
                          
                          1.4
                          %
                          
                          
                          208
                          
                          
                          
                          1.8
                          %CommercialCommercial
      and industrial
                          
                          
                          5,975
                          
                          
                          
                          20.7
                          %
                          
                          
                          4,794
                          
                          
                          
                          23.5
                          %
                          
                          
                          4,635
                          
                          
                          
                          21.6
                          %Agriculture
                          
                          
                          518
                          
                          
                          
                          2.2
                          %
                          
                          
                          222
                          
                          
                          
                          2.1
                          %
                          
                          
                          178
                          
                          
                          
                          2.4
                          %Other
                          
                          
                          -
                          
                          
                          
                          0.0
                          %
                          
                          
                          -
                          
                          
                          
                          0.1
                          %
                          
                          
                          1
                          
                          
                          
                          0.0
                          %ConstructionSingle
      family residential
                          
                          
                          237
                          
                          
                          
                          1.3
                          %
                          
                          
                          333
                          
                          
                          
                          2.1
                          %
                          
                          
                          304
                          
                          
                          
                          2.1
                          %Single
      family residential - Spec.
                          
                          
                          65
                          
                          
                          
                          0.4
                          %
                          
                          
                          159
                          
                          
                          
                          0.8
                          %
                          
                          
                          46
                          
                          
                          
                          0.5
                          %Tract
                          
                          
                          -
                          
                          
                          
                          0.0
                          %
                          
                          
                          222
                          
                          
                          
                          0.3
                          %
                          
                          
                          190
                          
                          
                          
                          0.3
                          %Multi-family
                          
                          
                          86
                          
                          
                          
                          0.3
                          %
                          
                          
                          730
                          
                          
                          
                          0.8
                          %
                          
                          
                          90
                          
                          
                          
                          0.3
                          %Hospitality
                          
                          
                          -
                          
                          
                          
                          0.0
                          %
                          
                          
                          79
                          
                          
                          
                          2.0
                          %
                          
                          
                          107
                          
                          
                          
                          2.0
                          %Commercial
                          
                          
                          626
                          
                          
                          
                          4.8
                          %
                          
                          
                          159
                          
                          
                          
                          3.2
                          %
                          
                          
                          270
                          
                          
                          
                          3.7
                          %Land
                          
                          
                          1,467
                          
                          
                          
                          4.8
                          %
                          
                          
                          2,302
                          
                          
                          
                          7.7
                          %
                          
                          
                          1,644
                          
                          
                          
                          7.2
                          %Installment
      loans to individuals
                          
                          
                          86
                          
                          
                          
                          1.1
                          %
                          
                          
                          32
                          
                          
                          
                          1.2
                          %
                          
                          
                          40
                          
                          
                          
                          1.1
                          %All
      other loans (including overdrafts)
                          
                          
                          65
                          
                          
                          
                          0.1
                          %
                          
                          
                          16
                          
                          
                          
                          0.1
                          %
                          
                          
                          16
                          
                          
                          
                          0.1
                          %Total
      allowance for loan losses
                          
                          $
                          21,571
                          
                          
                          
                          100.0
                          %
                          
                          $
                          15,873
                          
                          
                          
                          100.0
                          %
                          
                          $
                          14,372
                          
                          
                          
                          100.0
                          %





As of
September 30, 2010 the allocation of the allowance for loan losses to the real
estate secured segment of the loan portfolio has increased when compared to that
allocated to these categories in prior periods.  This is due in large
part to higher balances of classified real estate loans, an increase in specific
credit reserves within this segment, increased levels of credit losses and the
continued weakness in local state and economic
conditions.  Contributing further to the increase in the allocation to
the real estate secured segment of the portfolio was an increase in watch list
credits within this segment, specifically within commercial real
estate.





Increases
in the allocation to commercial and industrial balances can be attributed in
large part to higher credit losses within this segment in conjunction with the
continued weakened state of economic conditions.





A
reduction in the allocation to the land segment of the loan portfolio can be
attributed in part to lower levels of classified balances within this segment as
well as the charge-off of specific reserves within this segment.





Continued
weakness in economic conditions and any further deterioration in the credit
quality of the segments mentioned above may result in further significant
provisions for loan losses and increases in the allocation of the allowance to
those categories.





Credit
Quality and Non-Performing Assets





The
Company’s Management is responsible for monitoring loan performance and the
credit quality of the loan portfolio, which is done through various methods,
including frequent review of loan delinquencies and personal knowledge of
customers.  Additionally, the Company 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 Company to augment Management’s own internal review of the
portfolio.  A list of delinquencies, the watch list, internal loan
classifications and internal and external loan reviews are reviewed regularly by
the Company’s Board of Directors.


Heritage
Oaks Bancorp | - 59 -







The
Company has a non-accrual policy that requires a loan greater than 90 days past
due and/or 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.





Loans
typically move to non-accruing status from the Company’s “substandard” risk
grade.  When a loan is first classified as substandard, the Company
obtains updated appraisal information on the underlying collateral. Once the
updated appraisal is obtained and analyzed by Management, a valuation allowance,
if necessary, is established against such loan or a loss is recognized by a
charge to the allowance for loan losses if Management believes that the full
amount of the Company’s recorded investment in the loan is no longer
collectible.  Therefore, at the time a loan moves into non-accruing
status, a valuation allowance typically has already been established or balances
believed to be uncollectible on such loan have been charged-off.  The
Company orders new appraisals on underlying collateral in order to have the most
current indication of fair value, if appraisals obtained while the loan was
classified as substandard are deemed to be out dated.





In
certain instances a complete appraisal may take a significant amount of time to
complete.  In such cases, the Company may also rely on a broker’s
price opinion or other meaningful market data, such as comparable sales, in
order to derive its best estimate of a property’s fair value at the time the
decision to classify the loan as substandard, or move the loan to non-accruing
status, is made.  Once a loan is on non-accruing status an analysis of
the underlying collateral is performed at least quarterly.





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 Company 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 Company recognizes the loss by a charge to
non-interest expense.





The
weakened state of the economy and real estate markets have resulted in the
expansion of the Company’s internal watch list as well as the number of and
dollar volume of non-accruing loans when compared to historical
periods.  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
Company believes these actions will serve to potentially minimize any future
losses the Company may incur related to problem loans, no guarantee can be made
that the Company will not experience an increase in non-performing loans, given
continued uncertainties surrounding local, state and national economic
conditions.





As
evidenced in the table below summarizing the Company’s non-performing assets,
the current economic downturn has had a significant impact in regard to loans
related to land, construction, commercial and industrial and commercial real
estate.


Heritage
Oaks Bancorp | - 60 -







The
following table provides a summary of non-accruing loans as of September 30,
2010 and December 31, 2009:





September 30,
                              
                              
                              December 31,
                              
                              
                              Variance(dollars in thousands)
                              
                              2010
                              
                              
                              2009
                              
                              
                              Dollar
                              
                              
                              PercentLoans
      delinquent 90 days or more and still accruing
                              
                              $
                              52
                              
                              
                              $
                              151
                              
                              
                              $
                              (99
                              )
                              
                              
                              -65.56
                              %Non-Accruing
      LoansCommercial
      real estate
                              
                              $
                              13,245
                              
                              
                              $
                              11,035
                              
                              
                              $
                              2,210
                              
                              
                              
                              20.03
                              %Residential
      1-4 family
                              
                              
                              748
                              
                              
                              
                              1,147
                              
                              
                              
                              (399
                              )
                              
                              
                              -34.79
                              %Home
      equity lines of credit
                              
                              
                              320
                              
                              
                              
                              320
                              
                              
                              
                              -
                              
                              
                              
                              0.00
                              %Farmland
                              
                              
                              2,712
                              
                              
                              
                              -
                              
                              
                              
                              2,712
                              
                              
                              
                              100.00
                              %Commercial
      and industrial
                              
                              
                              3,694
                              
                              
                              
                              8,429
                              
                              
                              
                              (4,735
                              )
                              
                              
                              -56.18
                              %Agriculture
                              
                              
                              731
                              
                              
                              
                              3,172
                              
                              
                              
                              (2,441
                              )
                              
                              
                              -76.95
                              %Construction
                              
                              
                              2,798
                              
                              
                              
                              3,838
                              
                              
                              
                              (1,040
                              )
                              
                              
                              -27.10
                              %Land
                              
                              
                              2,244
                              
                              
                              
                              10,182
                              
                              
                              
                              (7,938
                              )
                              
                              
                              -77.96
                              %Installment
                              
                              
                              284
                              
                              
                              
                              47
                              
                              
                              
                              237
                              
                              
                              
                              504.26
                              %Total
      non-accruing loans
                              
                              $
                              26,776
                              
                              
                              $
                              38,170
                              
                              
                              $
                              (11,394
                              )
                              
                              
                              -29.85
                              %Other
      real estate owned
                              
                              $
                              9,031
                              
                              
                              $
                              946
                              
                              
                              $
                              8,085
                              
                              
                              
                              854.65
                              %Total
      non-performing assets
                              
                              $
                              35,859
                              
                              
                              $
                              39,267
                              
                              
                              $
                              (3,408
                              )
                              
                              
                              -8.68
                              %Ratio
      of allowance for credit losses to total gross loans
                              
                              
                              3.20
                              %
                              
                              
                              1.97
                              %Ratio
      of allowance for credit losses to total non-performing
    loans
                              
                              
                              80.40
                              %
                              
                              
                              37.50
                              %Ratio
      of non-performing loans to total gross loans
                              
                              
                              3.98
                              %
                              
                              
                              5.26
                              %Ratio
      of non-performing assets to total assets
                              
                              
                              3.62
                              %
                              
                              
                              4.15
                              %





At
September 30, 2010 the balance of non-accruing loans was approximately $26.8
million or $11.4 million lower than that reported at December 31,
2009.  Year to date changes in non-accruing balances can be attributed
in part to Management’s work-through of problem credits during
2010.  While a significant portion of these balances were charged-off,
the Company saw approximately $3.7 million in balances return to accruing status
following the Company’s efforts to work with certain borrowers to bring
resolution to problem credits.  Additionally, the Company transferred
approximately $12.1 million to foreclosed collateral status and has been
actively marketing such assets for eventual sale.  The Company also
received approximately $15.7 million in principal payments on non-accruing loans
during the first nine months of 2010, primarily the result of collateral
liquidations.





Non-performing
assets totaled approximately $35.9 million at September 30, 2010, approximately
$3.4 million lower than that reported at December 31, 2009.


Heritage
Oaks Bancorp | - 61 -







The
following table reconciles the change in non-accruing balances for the nine
months ended September 30, 2010:





Balance
                    
                    
                    Additions to
                    
                    
                    
                    
                    
                    Transfers
                    
                    
                    Returns to
                    
                    
                    
                    
                    
                    BalanceDecember 31,
                    
                    
                    Non-Accruing
                    
                    
                    Net
                    
                    
                    to Foreclosed
                    
                    
                    Preforming
                    
                    
                    
                    
                    
                    September 30,(dollars in thousands)
                    
                    2009
                    
                    
                    Balances
                    
                    
                    Paydowns
                    
                    
                    Collateral
                    
                    
                    Status
                    
                    
                    Charge-offs
                    
                    
                    2010Real
      Estate SecuredMulti-family
      residential
                    
                    $
                    -
                    
                    
                    $
                    -
                    
                    
                    $
                    -
                    
                    
                    $
                    -
                    
                    
                    $
                    -
                    
                    
                    $
                    -
                    
                    
                    $
                    -Residential
      1 to 4 family
                    
                    
                    1,147
                    
                    
                    
                    751
                    
                    
                    
                    (314
                    )
                    
                    
                    (235
                    )
                    
                    
                    -
                    
                    
                    
                    (601
                    )
                    
                    
                    748Home
      equity line of credit
                    
                    
                    320
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    320Commercial
                    
                    
                    11,035
                    
                    
                    
                    17,792
                    
                    
                    
                    (3,570
                    )
                    
                    
                    (5,590
                    )
                    
                    
                    (3,305
                    )
                    
                    
                    (3,117
                    )
                    
                    
                    13,245Farmland
                    
                    
                    -
                    
                    
                    
                    3,810
                    
                    
                    
                    (286
                    )
                    
                    
                    (577
                    )
                    
                    
                    -
                    
                    
                    
                    (235
                    )
                    
                    
                    2,712CommercialCommercial
      and industrial
                    
                    
                    8,429
                    
                    
                    
                    8,115
                    
                    
                    
                    (1,072
                    )
                    
                    
                    (50
                    )
                    
                    
                    (381
                    )
                    
                    
                    (11,347
                    )
                    
                    
                    3,694Agriculture
                    
                    
                    3,172
                    
                    
                    
                    1,160
                    
                    
                    
                    (2,348
                    )
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    (1,253
                    )
                    
                    
                    731Other
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -ConstructionSingle
      family residential
                    
                    
                    940
                    
                    
                    
                    -
                    
                    
                    
                    (610
                    )
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    (241
                    )
                    
                    
                    89Single
      family residential - Spec.
                    
                    
                    683
                    
                    
                    
                    1,250
                    
                    
                    
                    -
                    
                    
                    
                    (538
                    )
                    
                    
                    -
                    
                    
                    
                    (145
                    )
                    
                    
                    1,250Tract
                    
                    
                    2,215
                    
                    
                    
                    -
                    
                    
                    
                    (1,646
                    )
                    
                    
                    (363
                    )
                    
                    
                    -
                    
                    
                    
                    (206
                    )
                    
                    
                    -Multi-family
                    
                    
                    -
                    
                    
                    
                    900
                    
                    
                    
                    (4
                    )
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    (417
                    )
                    
                    
                    479Hospitality
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Commercial
                    
                    
                    -
                    
                    
                    
                    980
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    980Land
                    
                    
                    10,182
                    
                    
                    
                    5,221
                    
                    
                    
                    (5,800
                    )
                    
                    
                    (4,726
                    )
                    
                    
                    -
                    
                    
                    
                    (2,633
                    )
                    
                    
                    2,244Installment
      loans to individuals
                    
                    
                    47
                    
                    
                    
                    413
                    
                    
                    
                    (8
                    )
                    
                    
                    (35
                    )
                    
                    
                    -
                    
                    
                    
                    (133
                    )
                    
                    
                    284All
      other loans
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Totals
                    
                    $
                    38,170
                    
                    
                    $
                    40,392
                    
                    
                    $
                    (15,658
                    )
                    
                    $
                    (12,114
                    )
                    
                    $
                    (3,686
                    )
                    
                    $
                    (20,328
                    )
                    
                    $
                    26,776





Other
Real Estate Owned (“OREO”)





The
following table provides a summary for the year to date change in the balance of
OREO as of September 30, 2010:





Balance
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      BalanceDecember 31,
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      September 30,(dollars in thousands)
                      
                      2009
                      
                      
                      Additions
                      
                      
                      Disposals
                      
                      
                      Writedowns
                      
                      
                      2010Real
      Estate SecuredMulti-family
      residential
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      -Residential
      1 to 4 family
                      
                      
                      367
                      
                      
                      
                      235
                      
                      
                      
                      (198
                      )
                      
                      
                      (172
                      )
                      
                      
                      232Home
      equity line of credit
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Commercial
                      
                      
                      165
                      
                      
                      
                      5,590
                      
                      
                      
                      (363
                      )
                      
                      
                      (187
                      )
                      
                      
                      5,205Farmland
                      
                      
                      -
                      
                      
                      
                      577
                      
                      
                      
                      (577
                      )
                      
                      
                      -
                      
                      
                      
                      -CommercialCommercial
      and industrial
                      
                      
                      -
                      
                      
                      
                      50
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      50Agriculture
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Other
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -ConstructionSingle
      family residential
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Single
      family residential - Spec.
                      
                      
                      -
                      
                      
                      
                      538
                      
                      
                      
                      -
                      
                      
                      
                      (41
                      )
                      
                      
                      497Tract
                      
                      
                      -
                      
                      
                      
                      363
                      
                      
                      
                      -
                      
                      
                      
                      (69
                      )
                      
                      
                      294Multi-family
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Hospitality
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Commercial
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Land
                      
                      
                      414
                      
                      
                      
                      4,726
                      
                      
                      
                      (2,001
                      )
                      
                      
                      (386
                      )
                      
                      
                      2,753Installment
      loans to individuals
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -All
      other loans
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Totals
                      
                      $
                      946
                      
                      
                      $
                      12,079
                      
                      
                      $
                      (3,139
                      )
                      
                      $
                      (855
                      )
                      
                      $
                      9,031





At
September 30, 2010, OREO balances totaled approximately $9.0 million,
approximately $8.1 million higher than that reported at December 31,
2009.  During the first nine months of 2010 the Company transferred
approximately $12.1 million to OREO, disposed of approximately $3.1 million in
such assets, and incurred approximately $0.9 million in write-downs, resulting
primarily from updated appraisals.  Additions to OREO within the
commercial real estate category can be attributed in large part to two
properties securing two separate loans, totaling approximately $5.2
million.  The Company is actively marketing these properties for
eventual sale.  Additions in the construction and land categories can
be attributed to collateral securing five loans made to two
borrowers.  During the third quarter, the Company disposed of two of
the related properties and is currently marketing the remaining collateral for
eventual sale.


Heritage
Oaks Bancorp | - 62 -







Total
Cash and Cash Equivalents





Total
cash and cash equivalents were $57.1 million and $40.7 million at September 30,
2010 and December 31, 2009, respectively. This line item will vary depending on
cash letters from the previous night and actual cash on hand in the
branches.  Cash and cash equivalents were substantially higher than
that reported at December 31, 2009 due in large part to the proceeds the Company
received from the close of its March 2010 private placement as well as deposit
growth during the first nine months of 2010.  For additional
information related to the Company’s March 2010 private placement, please see
Note 11. Preferred Stock, of the consolidated financial statements filed on this
Form 10-Q.





Investment
Securities and Other Earning Assets





Other
earning assets are comprised of Interest Bearing Due from Federal Reserve,
Federal Funds Sold (funds the Company 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 Company, 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 September 30, 2010:





September 30,
                        
                        
                        December 31,
                        
                        
                        Variance(dollars in thousands)
                        
                        2010
                        
                        
                        2009
                        
                        
                        dollar
                        
                        
                        percentageInterest
      bearing due from banks
                        
                        $
                        34,936
                        
                        
                        $
                        17,046
                        
                        
                        $
                        17,890
                        
                        
                        
                        104.95
                        %Federal
      funds sold
                        
                        
                        5,500
                        
                        
                        
                        4,350
                        
                        
                        
                        1,150
                        
                        
                        
                        26.44
                        %Interest
      bearing deposits other financial institutions
                        
                        
                        119
                        
                        
                        
                        119
                        
                        
                        
                        -
                        
                        
                        
                        0.00
                        %Securities
      available for sale
                        
                        
                        202,218
                        
                        
                        
                        121,180
                        
                        
                        
                        81,038
                        
                        
                        
                        66.87
                        %Federal
      Home Loan Bank stock
                        
                        
                        5,395
                        
                        
                        
                        5,828
                        
                        
                        
                        (433
                        )
                        
                        
                        -7.43
                        %Total
      other earning assets
                        
                        $
                        248,168
                        
                        
                        $
                        148,523
                        
                        
                        $
                        99,645
                        
                        
                        
                        67.09
                        %





Federal
Funds Sold and Interest Bearing Due from Federal Reserve





As of
September 30, 2010, the total of federal funds sold and interest bearing due
from balances was approximately $40.4 million or $19.0 million higher than that
reported at December 31, 2009.  Although the balance of federal funds
sold and interest bearing due from can vary significantly from day to day as a
result of many factors, including the liquidity needs of the Company’s
depositors, the year to date increase, as previously mentioned, is mainly
attributable to funds received upon completion of the Company’s March 2010
private placement as well as a year to date increase in deposit balances,
resulting in excess funds available for short-term overnight
investment.





Investment
Securities





The
Company manages its securities portfolio to provide a source of both liquidity
and earnings.  The Company has an Asset/Liability Committee that
develops current investment policies based upon its operating needs and market
circumstance.  The Company’s investment policy is formally reviewed
and approved annually by the Board of Directors.  The Asset/Liability
Committee of the Company 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.





At
September 30, 2010, the balance of the investment portfolio was approximately
$202.2 million or $81.0 million higher than that reported at December 31,
2009.  The change in the balance of the portfolio can be attributed in
large part to purchases the Company made during the first nine months of the
year in the aggregate amount $105.4 million, principal pay downs on mortgage
related securities totaling approximately $17.6 million and proceeds from the
sale, call and maturity of investments totaling approximately $8.6
million.  During the nine months ended September 30, 2010 the Company
recorded a net pre-tax gain of approximately $0.7 million on the sale of various
investment securities.


Heritage
Oaks Bancorp | - 63 -







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 September 30, 2010 the securities portfolio had net
unrealized gains, net of taxes of approximately $0.4 million, an increase of
approximately $1.5 million from the unrealized loss reported at December 31,
2009.  Changes in the fair value of the investment portfolio in the
last two years can be attributed in part to extreme market turbulence, stemming
in part from continued weakened economic conditions and uncertain market
conditions and the volatility in interest rates.





During
the last two years, 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 Company’s portfolio was not immune to
this.  Although substantially all of the Company’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 during the last two years have,
among other things, been influential in placing pressure on the prices of these
types of securities.





At
September 30, 2010, the Company owned nine Whole Loan Private Label Mortgage
Backed Securities (“PMBS”) with a remaining principal balance of approximately
$15.9 million.  PMBS do not carry a government guarantee (explicit or
implicit) and require much more detailed due diligence in the form of pre and
post purchase analysis.  All PMBS bonds were rated AAA by one or more
of the major rating agencies at the time of purchase.  Due to the
severe and prolonged downturn in the economy PMBS bonds along with other asset
classes have seen deterioration in price, credit quality, and
liquidity.  Rating agencies have been reassessing all ratings
associated with bonds starting with lower tranche or subordinate pieces (which
have increased loss exposure) then moving on to senior and super senior bonds
which is what the Company owns with the exception of one mezzanine bond
(subordinate).  At September 30, 2010, five bonds with an aggregate
fair value of approximately $9.6 million remained below investment
grade.  All five of these bonds are in senior or super senior tranche
positions of their respective deals, meaning the Company has priority in cash
flows and has subordinate tranches below its position providing credit
support.





As more
fully disclosed in Note 2. Investments, of the consolidated financial statements
filed on this Form 10-Q, during the fourth quarter of 2009 the Company performed
an analysis, with the assistance of an independent third party, on several PMBS
in the investment portfolio for other than temporary impairment (“OTTI”),
including those mentioned in the previous paragraph.  Based on that
analysis, the Company determined four securities to be other than temporarily
impaired.  As a result, the Company realized approximately $372
thousand in aggregate pre-tax losses related to these securities during the
fourth quarter of 2009.  During the second quarter of 2010 the Company
sold one of the four securities mentioned above in an effort to take advantage
of current, more favorable, market pricing.  The Company recognized a
loss of approximately $150 thousand on the sale of this security.  The
loss recognized on the sale of this security was due to changes in market
pricing.





The
Company continues to engage an independent third party to review these same
securities for additional OTTI on a quarterly basis.  The results of
those analyses indicate there was additional OTTI related to credit impairment
on one bond in the amount of $106 thousand.  The Company recorded this
realized loss during the third quarter of 2010.  The Company will
continue to engage an independent third party to review these securities on a
quarterly basis for the foreseeable future.





The
Company continues to perform regular extensive analyses on PMBS bonds in the
portfolio including but not limited to updates on: credit enhancements,
loan-to-values, credit scores, delinquency rates and default
rates.  These investment securities continue to demonstrate cash flows
as expected, based on pre-purchase analyses.  As of September 30,
2010, Management does not believe that losses on PMBS in the portfolio, other
than those previously discussed, are other than temporary.





All PMBS
the Company owns are in senior or super senior tranche positions of their
respective deals, except for one mezzanine bond, meaning that the Company has
priority in cash flows and has subordinate tranches below its position providing
credit support.  The more credit support or enhancement, the more
protection is provided from possible losses on non-performing
collateral.  Credit support on PMBS the Company owns has increased
from the time of purchase through September 30, 2010, except for one
bond.  As the Company receives cash flow on its senior positions and
principle is reduced quicker than default losses are applied to the subordinate
positions, the credit enhancement percentage grows.





The
majority of the Company’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.  At September 30, 2010 approximately $153.0 million or 91.4%
of the Company’s mortgage related securities were issued by a government agency
such as those listed above.


Heritage
Oaks Bancorp | - 64 -







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 Company
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
Home Loan Bank (“FHLB”) Stock





As a
member of the Federal Home Loan Bank of San Francisco, the Company is required
to hold a specified amount of FHLB capital stock based on the level of
borrowings the Company has obtained from the FHLB.  As such, the
amount of FHLB stock the Company carries can vary from one period to another
based on among other things the current liquidity needs of the
Company.  At September 30, 2010 and December 31, 2009, the Company
held approximately $5.4 million and $5.8 million in FHLB stock,
respectively.  The year to date decline in the balance of FHLB stock
can be attributed to redemptions of approximately $0.4 million occurring in the
second and third quarters of 2010.





Deposits
and Borrowed Funds





The
following table provides a summary for the year to date change in various
categories of deposit balances as of September 30, 2010:





September 30,
                          
                          
                          December 31,
                          
                          
                          Variance(dollars in thousands)
                          
                          2010
                          
                          
                          2009
                          
                          
                          dollar
                          
                          
                          percentageNon-interest
      bearing demand
                          
                          $
                          176,419
                          
                          
                          $
                          174,635
                          
                          
                          $
                          1,784
                          
                          
                          
                          1.02
                          %Interest
      bearing demand
                          
                          
                          62,848
                          
                          
                          
                          77,765
                          
                          
                          
                          (14,917
                          )
                          
                          
                          -19.18
                          %Savings
                          
                          
                          27,630
                          
                          
                          
                          27,166
                          
                          
                          
                          464
                          
                          
                          
                          1.71
                          %Money
      market
                          
                          
                          292,852
                          
                          
                          
                          259,671
                          
                          
                          
                          33,181
                          
                          
                          
                          12.78
                          %Time
      deposits
                          
                          
                          235,025
                          
                          
                          
                          224,998
                          
                          
                          
                          10,027
                          
                          
                          
                          4.46
                          %Total
      retail deposits
                          
                          
                          794,774
                          
                          
                          
                          764,235
                          
                          
                          
                          30,539
                          
                          
                          
                          4.00
                          %Brokered
      time deposits
                          
                          
                          100
                          
                          
                          
                          10,230
                          
                          
                          
                          (10,130
                          )
                          
                          
                          -99.02
                          %Brokered
      money market funds
                          
                          
                          750
                          
                          
                          
                          1,000
                          
                          
                          
                          (250
                          )
                          
                          
                          -25.00
                          %Total
      brokered deposits
                          
                          
                          850
                          
                          
                          
                          11,230
                          
                          
                          
                          (10,380
                          )
                          
                          
                          -92.43
                          %Total
      deposits
                          
                          $
                          795,624
                          
                          
                          $
                          775,465
                          
                          
                          $
                          20,159
                          
                          
                          
                          2.60
                          %





Deposits





As
indicated in the table above total deposit balances at September 30, 2010 were
approximately $795.6 million.  This represents an increase of
approximately $20.2 million when compared to that reported at December 31,
2009.  Higher core deposit balances during 2009 allowed the Company to
rely less on wholesale funding and brokered deposits.  At September
30, 2010 brokered deposits totaled $0.9 million, representing a decline of
approximately $10.4 million from that reported at December 31,
2009.





During
the first nine months of 2010, the Company 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 $24.5 million from that reported at December 31,
2009.  In addition, those deposit accounts which the Company deems to
be volatile have decreased by $29.6 million and now represent an insignificant
approximate $2.1 or 0.3% of the total deposits of the Company.





Borrowed
Funds





The
Company has a variety of sources from which it may obtain secondary
funding.  These sources include, among others, the FHLB and credit
lines established with correspondent banks.  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.


Heritage
Oaks Bancorp | - 65 -







At
September 30, 2010, borrowings obtained from the FHLB comprised the majority of
borrowed funds.  The following table provides a summary of FHLB
borrowings the Company had outstanding as of September 30, 2010:





(dollars
in thousands)





Amount
                              
                              Interest
                              
                              MaturityBorrowed
                              
                              Rate
                              
                              
                              Advance Type
                              
                              Date$
                              20,000
                              
                              
                              0.22
                              %
                              
                              Variable
                              
                              Open35,000
                              
                              
                              0.36
                              %
                              
                              Adjustable
                              
                              1/31/2011$
                              55,000
                              
                              
                              0.31
                              %





As
evidenced in the table above, the balance of FHLB borrowing as of September 30,
2010 was $55.0 million a decline of $10.0 million from the balance reported at
December 31, 2009.





On
September 17, 2004, the Company 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 to support the primary financing of a senior care
facility.  The Letter of Credit was issued pursuant to a Letter of
Credit Reimbursement Agreement between the Company and the FHLB.  It
is collateralized by a blanket lien with the FHLB that includes all qualifying
loans on the Company’s balance sheet.  The letter of credit was
renewed in September 2010 and will expire in September 2011.  The
letter of credit was undrawn as of September 30, 2010.





Capital





At
September 30, 2010, the balance of stockholders’ equity was approximately $122.6
million.  This represents an increase of approximately $38.8 million
over that reported at December 31, 2009.  The year to date change in
capital is due primarily to $60.0 million in gross proceeds the Company raised
in its March 2010 private placement.  Additionally, the year to date
change is also attributed to net losses of $18.1 million, the impact of year to
date share-based compensation expense in the amount of $0.2 million, dividends
paid and accrued on Series A Senior Preferred stock in the amount of $0.8
million, proceeds from the exercise of options in the amount of $42 thousand and
a decline in the balance of accumulated other comprehensive loss in the amount
of $1.5 million.





Private
Placement and Preferred Stock Conversion





On March
12, 2010 the Company completed a private placement of 52,088 shares of its
Series B Mandatorily Convertible Adjustable Cumulative Perpetual Preferred Stock
("Series B Preferred Stock") and 1,189,538 shares of its Series C Convertible
Perpetual Preferred Stock, raising gross proceeds of approximately $56.0
million.  In addition, approximately $4.0 million was placed in escrow
for a second closing of 4,072 shares of Series B Preferred Stock.  The
second closing was later completed in the second quarter of 2010. Following the
receipt of shareholder approval at the Company’s June 2010 annual meeting, the
Company converted to common stock all Series B Preferred shares issued in its
private placement.  The total number of common shares issued in the
conversion was 17,279,995. For additional information regarding the Company’s
private placement, please see Note 11. Preferred Stock, of the consolidated
financial statements filed on this Form 10-Q.





U.S.
Treasury CPP Series A Senior Preferred Stock





On March
20, 2009, the Company issued $21.0 million in Series A Senior Preferred Stock to
the U.S. Treasury as part of its participation in the CPP. 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.  Under the terms of 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.  In the second quarter of 2010, the
Company notified the U.S. Treasury that pursuant to a Written Agreement entered
into between the Company and the Federal Reserve Bank of San Francisco, the
Company was required to defer dividend payments on its Senior Preferred
Stock.  If the Company fails to pay dividends on Series A Senior
Preferred Stock for a total of six quarters, whether or not consecutive, the
U.S. Treasury will have the right to elect two members of the Company’s Board of
Directors, voting together with any other holders of preferred shares ranking
pari passu with the
Series A Senior Preferred Stock. These directors would serve on the Company’s
Board of Directors until such time as the Company has paid in full all dividends
not previously paid, at which time these directors’ terms of office would
immediately terminate.


Heritage
Oaks Bancorp | - 66 -







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 Series A Senior Preferred Stock
and its participation in the CPP, see Note 11 of the consolidated financial
statements filed on this Form 10-Q.





Dividends





During
the first nine months of 2010, the Company paid a dividend of approximately $0.3
million on its Series A Senior Preferred Stock issued to the U.S. Treasury under
the CPP.  The payment of this dividend occurred in the first quarter
of 2010.





As
mentioned above, the Company, pursuant to a Written Agreement between it and
Federal Reserve Bank of San Francisco was required to defer dividends payments
on the Senior Preferred Stock issued to the U.S. Treasury under the
CPP.  For more information concerning the Written Agreement, please
refer to Note 12. Regulatory Order and Written Agreement of the consolidated
financial statements filed on this Form 10-Q.





The
Company paid no dividends on its common stock during the first nine months of
2010.





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 the Company’s common stock.





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 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 growth.





In June
2010 the Company announced it had used $3.3 million of the $4.0 million in
proceeds received from the second closing of its March 2010 private placement to
repurchase the $5.0 million in face amount trust preferred securities issued by
Heritage Oaks Capital Trust III, and the related junior subordinated debentures
issued by the Company. The repurchase resulted in a pre-tax gain of
approximately of $1.7 million. The repurchase was made pursuant to the
non-objection of the Federal Reserve Bank of San Francisco and approval of the
United States Treasury Department.  The Company intends to dissolve
Heritage Oaks Capital Trust III in the second half of 2010.





At
September 30, 2010, the Company had at total of $8.2 million in Junior
Subordinated Deferrable Interest Debentures issued and
outstanding.  As mentioned in the preceding paragraphs, these
securities have been issued to Trust II.  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 Trust II,
totaling $248 thousand.  The balance of the equity of Trust II is
comprised of mandatory redeemable preferred securities and is included in other
assets.  Interest associated with the securities issued to Trust II is
payable quarterly and varies at 3-month LIBOR plus 1.72%.





The
following table provides a summary of the securities the Company has issued to
Trust II as of September 30, 2010:





Amount
                                
                                
                                Current
                                
                                Issue
                                
                                Scheduled
                                
                                Call(dollars in thousands)
                                
                                Issued
                                
                                
                                Rate
                                
                                Date
                                
                                Maturity
                                
                                Date
                                
                                Rate TypeHeritage
      Oaks Capital Trust II
                                
                                $
                                8,248
                                
                                
                                
                                2.25
                                %
                                27-Oct-06
                                
                                Aug-37
                                
                                Nov-11
                                
                                Variable
      3-month LIBOR +
1.72%





The
Company has the right under the indenture 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 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 agreement.


Heritage
Oaks Bancorp | - 67 -







Pursuant
to U.S. GAAP, the Company is not allowed to consolidate Trust II into the
Company’s financial statements.  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 September 30,
2010, the Company included $8.0 million of the net junior subordinated debt in
its Tier I Capital for regulatory capital purposes.





At
September 30, 2010, the Company had sufficient cash to service the $8.2 million
in junior subordinated debenture interest payments and other obligations, such
as the payment of dividends on the preferred stock issued to the U.S. Treasury,
for approximately 5.7 years without dividends from
subsidiaries.  However, in the second quarter of 2010, the Company, in
order to comply with the terms of the Written Agreement entered into with the
Federal Reserve Bank of San Francisco, was required to defer interest payments
on its trust preferred securities. For more information concerning the Written
Agreement, please refer to Note 12. Regulatory Order and Written Agreement of
the consolidated financial statements filed on this Form 10-Q.





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 Company 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.





To be
categorized as well-capitalized, the Bank must maintain minimum capital ratios
as set forth in the table below. However, on February 26, 2010, the Bank
stipulated to the issuance of an Order that was issued March 4, 2010, by the
FDIC and DFI that requires higher levels of Tier I Leverage and Total Risk Based
ratios.  Under the Order the Bank must maintain a Tier I Leverage
ratio of 10.0% and a Total Risk-Based Capital ratio of 11.5%.  See
also Note 12. Regulatory Order and Written Agreement of the consolidated
financial statements for additional information related to the Consent Oder as
they pertain to these requirements.





The
following table provides a summary of Company and Bank regulatory capital ratios
at September 30, 2010 and 2009:





Regulatory Standard
                
                
                September 30, 2010
                
                
                September 30, 2009Adequately
                
                
                Well
                
                
                Heritage Oaks
                
                
                Heritage OaksRatio
                
                Capitalized
                
                
                Capitalized
                
                
                Bancorp
                
                
                Bank
                
                
                Bancorp
                
                
                BankLeverage
      ratio
                
                
                4.00
                %
                
                
                5.00
                %
                
                
                11.48
                %
                
                
                10.95
                %
                
                
                9.30
                %
                
                
                8.76
                %Tier
      I capital to risk weighted assets
                
                
                4.00
                %
                
                
                6.00
                %
                
                
                15.41
                %
                
                
                14.64
                %
                
                
                10.52
                %
                
                
                9.86
                %Total
      risk based capital to risk weighted assets
                
                
                8.00
                %
                
                
                10.00
                %
                
                
                16.68
                %
                
                
                15.91
                %
                
                
                11.78
                %
                
                
                11.12
                %





Regulatory
capital ratios as of September 30, 2010 fully reflect the $60.0 million in gross
proceeds the Company raised through the issuance of Series B and Series C
Preferred Stock in a private placement during the first six months of 2010.
Following the receipt of shareholder approval at the Company’s June 2010 annual
meeting, the Company converted to common stock all Series B Preferred shares
issued in its private placement.  The conversion of preferred to
common stock is fully reflected in the capital ratios above. Following the
receipt of proceeds from the private placement, the Company down-streamed $48.0
million to the Bank as Tier I capital.  These regulatory ratios also
fully reflect the issuance of $21.0 million in Series A Senior Preferred Stock
to the U.S. Treasury as part of the Company’s participation in the U.S.
Treasury’s CPP.


Heritage
Oaks Bancorp | - 68 -







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 Company’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
Company’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 Company’s customers serve as the
primary source of liquidity.  The Company has credit arrangements with
correspondent banks that serve as a secondary liquidity source.  At
September 30, 2010, these credit lines totaled $15.0 million and the Company had
no borrowings against those lines.  As previously mentioned the
Company is a member of the FHLB and has collateralized borrowing capacities
remaining of approximately $85.8 million at September 30,
2010.  Additionally, the Company has established and tested a
borrowing facility with the Federal Reserve.  The amount of available
credit is determined by the collateral provided by the Company at the time of a
transaction.





The
Company manages liquidity by maintaining a majority of the investment portfolio
in Interest Bearing Due from Federal Reserve and other liquid
investments.  Most 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
September 30, 2010, 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 31.89% at September 30,
2010 compared to 20.50% at December 31, 2009.  At September 30, 2010,
the Company was within its internal guideline for liquidity.  As of
September 30, 2010 the fair market value of the Company’s investment portfolio
was approximately $202.2 million, of which approximately $10.1 million was
pledged to secure public deposits and other purposes. The ratio of gross loans
to deposits (“LTD”), another key liquidity ratio, was 84.7% at September 30,
2010 compared to 94.0% at December 31, 2009 both of which are and were within
the Company’s policy guidelines.





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 11 to the Company’s Consolidated Financial
Statements under Item 8 of Part II of the Company’s December 31, 2009 Annual
Report filed on Form 10-K.





In the
ordinary course of business, the Company is a party to various operating
leases.  For a more detailed discussion of these financial
instruments, refer to Note 11 to the Company’s Consolidated Financial Statements
under Item 8 of Part II of the Company’s December 31, 2009 Annual Report filed
on Form 10-K.





In
connection with the $8.2 million in debt securities discussed under “Capital,” the Company issued
the full and unconditional payment guarantee of certain accrued
distributions.


Heritage
Oaks Bancorp | - 69 -


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 $8.2 million in
subordinated debentures issued by the Company’s subsidiary grantor trust. As a
result, all significant interest rate risk procedures are performed at the
banking subsidiary level. The subsidiary Company’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 Company’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 Company’s interest rate
sensitivity.  Based on the results of this model, Management believes
the Company’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 Company’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 September 30,
2010 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 September 30, 2010, 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)
                  
                  $
                  44,255
                  
                  
                  $
                  45,589
                  
                  
                  $
                  44,503
                  
                  
                  $
                  43,229
                  
                  
                  $
                  42,457$
      Change from base
                  
                  $
                  (248
                  )
                  
                  $
                  1,086
                  
                  
                  $
                  -
                  
                  
                  $
                  (1,274
                  )
                  
                  $
                  (2,046
                  )%
      Change from base
                  
                  
                  -0.56
                  %
                  
                  
                  2.44
                  %
                  
                  
                  0.00
                  %
                  
                  
                  -2.86
                  %
                  
                  
                  -4.60
                  %





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.


Heritage
Oaks Bancorp | - 70 -





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 September
30, 2010:





(dollars
      in thousands)Percent
      ofRate Type
                        
                        Balance
                        
                        
                        TotalVariable
      – daily
                        
                        $
                        218,867
                        
                        
                        
                        32.5
                        %Variable
      other than daily
                        
                        
                        333,420
                        
                        
                        
                        49.5
                        %Fixed
      rate
                        
                        
                        121,596
                        
                        
                        
                        18.0
                        %Total
      gross loans
                        
                        $
                        673,882
                        
                        
                        
                        100.0
                        %





The table
above identifies approximately 32.5% of the loan portfolio that will re-price
immediately in a changing rate environment.  At September 30, 2010,
approximately $552.3 million or 82.0% of the Company’s loan portfolio is
considered variable.





(dollars
      in thousands)Percent
      ofRe-Pricing
                        
                        Balance
                        
                        
                        Total<
      1 Year
                        
                        $
                        391,763
                        
                        
                        
                        58.1
                        %1-3
      Years
                        
                        
                        191,710
                        
                        
                        
                        28.5
                        %3-5
      Years
                        
                        
                        59,563
                        
                        
                        
                        8.8
                        %>
      5 Years
                        
                        
                        30,846
                        
                        
                        
                        4.6
                        %Total
      gross loans
                        
                        $
                        673,882
                        
                        
                        
                        100.0
                        %





The
following table provides a summary of the loans the Company can expect to see
adjust above their floor rates if the Prime rate were to increase by the amounts
identified below as of September 30, 2010:





Move in Prime Rate (bps)(dollars in thousands)
                          
                          
                          +200
                          
                          
                          
                          +250
                          
                          
                          
                          +300
                          
                          
                          
                          +350Variable
      daily
                          
                          $
                          887
                          
                          
                          $
                          12,042
                          
                          
                          $
                          56,092
                          
                          
                          $
                          109,426Variable
      other than daily
                          
                          
                          2,370
                          
                          
                          
                          15,178
                          
                          
                          
                          62,293
                          
                          
                          
                          178,740Cumulative
      total variable at floor
                          
                          $
                          3,257
                          
                          
                          $
                          27,220
                          
                          
                          $
                          118,385
                          
                          
                          $
                          288,166





Given the
significant decline in Prime rate over the last two years, many loans in the
portfolio possess floors significantly higher than the current Prime
rate.  Therefore, the Company 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, 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 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.


Heritage
Oaks Bancorp | - 71 -





In
connection with the revision to the consolidated financial statements as
described in the Explanatory Note of the June 30, 2010 10-Q/A, filed on
September 24, 2010 (the “10-Q/A”), Management reevaluated the effectiveness
of the design and operation of the Company’s disclosure controls and procedures
as of June 30, 2010. In connection therewith, Management identified a material
weakness in internal control over financial reporting.  Management
determined that the Company did not maintain effective control over the
financial reporting process utilized to interpret the applicable accounting
literature for computing and allocating the amount attributable to the
contingent beneficial conversion feature related to the issuance of Series B
Preferred Stock as well as the disclosure of the contingent beneficial
conversion feature related to the Series C Preferred Stock, as more fully
described in the Explanatory Note on page 2 of the 10-Q/A. Management believes
this control deficiency resulted in a misstatement of the net loss applicable to
common shareholders.  As a result of this material weakness, Management
concluded that the Company’s disclosure controls were not effective as of June
30, 2010.  In light of the material weakness described above, Management
revised its consolidated financial statements in the 10-Q/A as discussed
previously to ensure that the computation and allocation of the beneficial
conversion feature related to the Series B Preferred Stock and the disclosure of
the contingent beneficial conversion feature associated with the Series C
Preferred Stock was in conformity with the applicable accounting
guidance.  Management also believes that the consolidated financial
statements included in the Company’s 10-Q/A were prepared in accordance with
U.S. generally accepted accounting principles (“GAAP”) in all material
respects.





Remediation
of Material Weakness





The
Company is in the process of actively remediating this material
weakness.  The Company is focusing remediation efforts on establishing
additional financial reporting processes when events or transactions occur
outside of the Company’s usual and routine course of business.





Management
believes the additional control procedure, upon implementation, will remediate
this material weakness.  Management will validate, through testing of
internal controls, the effectiveness of this remediation.  However,
the effectiveness of any system of internal controls is subject to inherent
limitations and there can be no assurance that the Company’s internal control
over financial reporting will prevent or detect all errors.  The
Company will continue to evaluate and strengthen its internal control over
financial reporting system in order to prevent future errors in financial
reporting.





Changes
in Internal Control Over Financial Reporting





There was
no change in the Company’s internal controls over financial reporting during the
quarter ended September 30, 2010 that has materially affected, or is reasonably
likely to materially affect, the Company’s internal controls over financial
reporting. However, as of the date of this report, and as mentioned above,
Management is in the process of remediating the material weakness disclosed
above.  Management believes that the material weakness it has
identified will be remediated by the quarter ended December 31,
2010.





Part
II.  Other Information





Item
1.  Legal Proceedings





The Bank
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,
was 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 Bank believes
the action against it is without merit.  The matter has been tendered to
the Bank's insurance carrier, and the Bank is actively defending the case. 
The Bank demurred to the amended complaint and the court upheld the demurrer to
the cause of action for negligence. Discovery is proceeding and it appears that
mediation will take place. The Bank anticipates a favorable outcome to the case
and does not expect the litigation to have any material financial impact to the
Bank.





Gardality
v. Heritage Oaks Bank, et al.  San Diego County Sup. Ct. Case no.
37-2010-00055218-CU-NC. Plaintiff sued the Bank and 157 other defendants. 
The pleading indicates the plaintiff’s claim is connected to funds he borrowed
from Estate Financial, Inc. (“EFI”) as the developer of a real estate
project.  EFI was a customer of the Bank and is now a debtor in a
bankruptcy proceeding.  The complaint was poorly written and legally
deficient to the point where it is impossible to determine the nature or
validity of the claim.  The Bank had no contact with the plaintiff prior to
service of the complaint and believes that plaintiff’s action against it is
without merit.  The matter has been tendered to the Bank’s insurance
carrier and the Bank is actively defending the case.  The plaintiff
dismissed the defective complaint against the Bank at the Bank’s request, and
has not filed a new complaint as of this date. The Bank currently anticipates a
favorable outcome to the matter and does not expect the litigation to have any
material financial impact to the Bank.


Heritage
Oaks Bancorp | - 72 -





Except as
indicated above, neither the Bank nor the Company is involved in any legal
proceedings other than routine legal proceedings occurring in the ordinary
course of business.  Such routine legal proceedings, in the aggregate, are
believed by Management to be immaterial to the financial condition, results of
operations and cash flows of the Company as of September 30, 2010.





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, 2009 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





(a)
            None.





(b)
            In
      the second quarter of 2010 the Company was required to defer dividend
      payments on its Series A Senior Preferred Stock issued to the U.S.
      Treasury under the CPP in order to comply with the terms of the Written
      Agreement entered into between the Company and the Federal Reserve Company
      of San Francisco.  For more information concerning the Written
      Agreement, please refer to Note 12. Regulatory Order and Written Agreement
      of the consolidated financial statements filed on this Form
      10-Q.  As of September 30, 2010, the Company has deferred two
      dividend payment on its Series A Senior Preferred Stock totaling
      approximately $0.5 million.





Item
4.  (Removed and Reserved)





None.





Item
5.  Other Information





Not
applicable.


Heritage
Oaks Bancorp | - 73 -


Item
6.  Exhibits





(a)
Exhibits:





Exhibit
      (31.1)
                
                Certification
      of Chief Executive 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 2002


Heritage
Oaks Bancorp | - 74 -


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 Bancorp





Date:
November 12, 2010





/s/ Lawrence P. WardLawrence
      P. WardChief
      Executive Officer(Principal
      Executive Officer)(Principal
      Financial Officer)


Heritage
Oaks Bancorp | - 75 -