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 March 31, 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 April 30, 2010 there
were 7,783,212 shares outstanding of the Registrant’s common stock.









PagePart
      I.  Financial Information
                  
                  3Item
      1.  Consolidated Financial Statements (un-audited, except for
      Balance Sheet as of 12/31/2009)
                  
                  3Consolidated
      Balance Sheets
                  
                  4Consolidated
      Statements of Income
                  
                  5Consolidated
      Statements of Stockholders' Equity
                  
                  6Consolidated
      Statements of Comprehensive IncomeConsolidated
      Statements of Cash Flows
                  
                  7Notes
      to Consolidated Financial Statements
                  
                  8Note
      1.  Consolidated Financial Statements
                  
                  8Note
      2.  Investment Securities
                  
                  8Note
      3.  Loans and the Allowance for Loan Losses
                  
                  12Note
      4.  Other Real Estate Owned
                  
                  15Note
      5.  Deferred Tax Assets
                  
                  15Note
      6.  Earnings Per Share
                  
                  16Note
      7.  Recent Accounting Pronouncements
                  
                  17Note
      8.  Share-Based Compensation
                  
                  18Note
      9.  Fair Value Disclosures
                  
                  20Note
      10.  Fair Value of Financial Instruments
                  
                  21Note
      11.  Preferred Stock
                  
                  24Note
      12.  Consent Order and Written Agreement
                  
                  26Note
      13.  Reclassifications
                  
                  28Forward
      Looking Statements
                  
                  29Item
      2.  Management's Discussion and Analysis of Financial Condition
      and Results of Operations
                  
                  30The
      Company
                  
                  30Where
      You Can Find More Information
                  
                  30Executive
      Summary
                  
                  31Recent
      Developments
                  
                  33Dividends
      and Stock Repurchases
                  
                  34Selected
      Financial Data
                  
                  35Local
      Economy
                  
                  35Critical
      Accounting Policies
                  
                  36Results
      of Operations
                  
                  39Net
      Interest Income and Margin
                  
                  39Non-Interest
      Income
                  
                  43Non-Interest
      Expenses
                  
                  44Provision
      for Income Taxes
                  
                  45Provision
      for Loan Losses
                  
                  45Financial
      Condition
                  
                  48Loans
                  
                  48Credit
      Quality
                  
                  53Allowance
      for Loan Losses
                  
                  53Non-Performing
      Assets
                  
                  55Total
      Cash and Cash Equivalents
                  
                  59Investment
      Securities and Other Earning Assets
                  
                  59Deposits
      and Borrowed Funds
                  
                  62Capital
                  
                  63Liquidity
                  
                  65Inflation
                  
                  66Off-Balance
      Sheet Arrangements
                  
                  66Item
      3.  Quantative and Qualitative Disclosure About Market
      Risk
                  
                  67Item
      4.  Controls and Procedures
                  
                  68Part
      II.  Other Information
                  
                  69Item
      1.  Legal Proceedings
                  
                  69Item
      1A.  Risk Factors
                  
                  69Item
      2.  Unregistered Sales of Equity Securities and Use of
      Proceeds
                  
                  69Item
      3.  Defaults upon Senior Securities
                  
                  69Item
      4.  (Removed and Reserved)
                  
                  69Item
      5.  Other Information
                  
                  70Item
      6.  Exhibits
                  
                  70Signatures
                  
                  71







Heritage
Oaks Bancorp | - 2 -





Part
I.  Financial Information





Item
1. Consolidated Financial Statements





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







Heritage
Oaks Bancorp | - 3 -





Heritage
Oaks Bancorp


and
Subsidiaries


Consolidated
Balance Sheets





(audited)March 31,
                    
                    
                    December 31,(dollars in thousands except per share
      data)
                    
                    2010
                    
                    
                    2009AssetsCash
      and due from banks
                    
                    $
                    20,997
                    
                    
                    $
                    19,342Interest
      bearing due from Federal Reserve Bank
                    
                    
                    97,898
                    
                    
                    
                    17,046Federal
      funds sold
                    
                    
                    1,430
                    
                    
                    
                    4,350Total
      cash and cash equivalents
                    
                    
                    120,325
                    
                    
                    
                    40,738Interest
      bearing deposits other financial institutions
                    
                    
                    119
                    
                    
                    
                    119Securities
      available for sale
                    
                    
                    128,388
                    
                    
                    
                    121,180Federal
      Home Loan Bank stock, at cost
                    
                    
                    5,828
                    
                    
                    
                    5,828Loans
      held for sale
                    
                    
                    7,815
                    
                    
                    
                    9,487Loans,
      net of deferred fees of $1,699 and $1,825 and allowance for loan loss of
      $18,559 and $14,372 at March 31, 2010 and December 31, 2009,
      respectively.
                    
                    
                    702,485
                    
                    
                    
                    712,482Property,
      premises and equipment, net
                    
                    
                    6,496
                    
                    
                    
                    6,779Deferred
      tax assets
                    
                    
                    11,654
                    
                    
                    
                    10,553Bank
      owned life insurance
                    
                    
                    12,684
                    
                    
                    
                    12,549Goodwill
                    
                    
                    11,049
                    
                    
                    
                    11,049Core
      deposit intangible
                    
                    
                    2,513
                    
                    
                    
                    2,642Other
      real estate owned
                    
                    
                    741
                    
                    
                    
                    946Other
      assets
                    
                    
                    9,395
                    
                    
                    
                    10,825Total
      assets
                    
                    $
                    1,019,492
                    
                    
                    $
                    945,177LiabilitiesDepositsDemand,
      non-interest bearing
                    
                    $
                    178,976
                    
                    
                    $
                    174,635Savings,
      NOW, and money market deposits
                    
                    
                    378,726
                    
                    
                    
                    365,602Time
      deposits of $100 or more
                    
                    
                    121,106
                    
                    
                    
                    117,420Time
      deposits under $100
                    
                    
                    116,608
                    
                    
                    
                    117,808Total
      deposits
                    
                    
                    795,416
                    
                    
                    
                    775,465Short
      term FHLB borrowing
                    
                    
                    65,000
                    
                    
                    
                    65,000Other
      secured borrowing
                    
                    
                    2,479
                    
                    
                    
                    -Junior
      subordinated debentures
                    
                    
                    13,403
                    
                    
                    
                    13,403Other
      liabilities
                    
                    
                    7,975
                    
                    
                    
                    7,558Total
      liabilities
                    
                    
                    884,273
                    
                    
                    
                    861,426Commitments
      and contingencies
                    
                    
                    -
                    
                    
                    
                    -Stockholders'
      EquitySeries
      A senior preferred stock, $1,000 per share stated value, 21,000 shares
      issued and outstanding
                    
                    
                    19,520
                    
                    
                    
                    19,431Series
      B preferred stock, $1,000 per share stated value, 52,088 shares issued and
      outstanding
                    
                    
                    48,469
                    
                    
                    
                    -Series
      C preferred stock, $3.25 per share stated value, 1,189,538 shares issued
      and outstanding
                    
                    
                    3,866
                    
                    
                    
                    -Common
      stock, no par value; 20,000,000 shares authorized, issued and outstanding
      7,783,212 and 7,771,952 as of March 31, 2010 and December 31, 2009,
      respectively.
                    
                    
                    48,789
                    
                    
                    
                    48,747Additional
      paid in capital
                    
                    
                    3,341
                    
                    
                    
                    3,242Retained
      earnings
                    
                    
                    11,717
                    
                    
                    
                    13,407Accumulated
      other comprehensive loss, net of tax benefit of $338 and $752 as of March
      31, 2010 and December 31, 2009, respectively.
                    
                    
                    (483
                    )
                    
                    
                    (1,076
                    )Total
      stockholders' equity
                    
                    
                    135,219
                    
                    
                    
                    83,751Total
      liabilities and stockholders' equity
                    
                    $
                    1,019,492
                    
                    
                    $
                    945,177





See notes
to condensed consolidated financial statements.







Heritage
Oaks Bancorp | - 4 -


Heritage
Oaks Bancorp


and
Subsidiaries


Consolidated
Statements of Income





For the three months endedMarch 31,(dollars in thousands except per share
      data)
                
                2010
                
                
                2009Interest
      IncomeInterest
      and fees on loans
                
                $
                11,141
                
                
                $
                11,147Interest
      on investment securitiesMortgage
      backed securities
                
                
                1,019
                
                
                
                548Obligations
      of state and political subdivisions
                
                
                257
                
                
                
                186Interest
      on time deposits with other banks
                
                
                -
                
                
                
                1Interest
      on due from Federal Reserve Bank
                
                
                28
                
                
                
                -Interest
      on federal funds sold
                
                
                1
                
                
                
                7Interest
      on other securities
                
                
                4
                
                
                
                7Total
      interest income
                
                
                12,450
                
                
                
                11,896Interest
      ExpenseInterest
      on savings, NOW and money market deposits
                
                
                1,082
                
                
                
                817Interest
      on time deposits in denominations of $100 or more
                
                
                576
                
                
                
                544Interest
      on time deposits under $100
                
                
                613
                
                
                
                564Other
      borrowings
                
                
                232
                
                
                
                404Total
      interest expense
                
                
                2,503
                
                
                
                2,329Net
      interest income before provision for possible loan losses
                
                
                9,947
                
                
                
                9,567Provision
      for possible loan losses
                
                
                5,200
                
                
                
                2,110Net
      interest income after provision for possible loan losses
                
                
                4,747
                
                
                
                7,457Non
      Interest IncomeFees
      and service charges
                
                
                625
                
                
                
                712Gain
      on sale of investment securities
                
                
                -
                
                
                
                122Loss
      on sale of OREO
                
                
                -
                
                
                
                (27
                )Other
                
                
                961
                
                
                
                853Total
      non interest income
                
                
                1,586
                
                
                
                1,660Non
      Interest ExpenseSalaries
      and employee benefits
                
                
                4,378
                
                
                
                3,803Occupancy
                
                
                933
                
                
                
                852Equipment
                
                
                328
                
                
                
                325Other
                
                
                3,227
                
                
                
                2,445Total
      non interest expense
                
                
                8,866
                
                
                
                7,425(Loss)
      / income before provision for income taxes
                
                
                (2,533
                )
                
                
                1,692(Benefit)
      / provision for income taxes
                
                
                (1,194
                )
                
                
                590Net
      (loss) / income
                
                
                (1,339
                )
                
                
                1,102Dividends
      and accretion on preferred stock
                
                
                351
                
                
                
                11Net
      (loss) / income available to common shareholders
                
                $
                (1,690
                )
                
                $
                1,091(Loss)
      / Earnings Per Common ShareBasic
                
                $
                (0.22
                )
                
                $
                0.14Diluted
                
                $
                (0.22
                )
                
                $
                0.14





See notes
to condensed consolidated financial statements.







Heritage
Oaks Bancorp | - 5 -


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 / (Loss)
                              
                              
                              Earnings
                              
                              
                              Income / (Loss)
                              
                              
                              EquityBalance,
      December 31, 2009
                              
                              $
                              19,431
                              
                              
                              
                              7,771,952
                              
                              
                              $
                              48,747
                              
                              
                              $
                              3,242
                              
                              
                              
                              
                              
                              $
                              13,407
                              
                              
                              $
                              (1,076
                              )
                              
                              $
                              83,751Issuance
      of 52,088 shares of Series B preferred stock
                              
                              
                              48,469
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              48,469Issuance
      of 1,189,538 shares of Series C preferred stock
                              
                              
                              3,866
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              3,866Accretion
      on Series A preferred stock
                              
                              
                              89
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              (89
                              )
                              
                              
                              
                              
                              
                              
                              -Dividends
      paid on preferred stock
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              (262
                              )
                              
                              
                              
                              
                              
                              
                              (262
                              )Exercise
      of stock options
                              
                              
                              
                              
                              
                              
                              11,260
                              
                              
                              
                              42
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              42Share-based
      compensation expense
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              99
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              99Comprehensive
      incomeNet
      loss
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              $
                              (1,339
                              )
                              
                              
                              (1,339
                              )
                              
                              
                              
                              
                              
                              
                              (1,339
                              )Unrealized
      security holding gain (net of $414 tax)
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              593
                              
                              
                              
                              
                              
                              
                              
                              593
                              
                              
                              
                              593Total
      comprehensive loss
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              $
                              (746
                              )Balance,
      March 31, 2010
                              
                              $
                              71,855
                              
                              
                              
                              7,783,212
                              
                              
                              $
                              48,789
                              
                              
                              $
                              3,341
                              
                              
                              
                              
                              
                              
                              $
                              11,717
                              
                              
                              $
                              (483
                              )
                              
                              $
                              135,219Balance,
      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
                              
                              
                              11
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              (11
                              )
                              
                              
                              
                              
                              
                              
                              -Share-based
      compensation expense
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              90
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              90Retirement
      of restricted share awards
                              
                              
                              
                              
                              
                              
                              (1,312
                              )
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              -Comprehensive
      incomeNet
      income
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              $
                              1,102
                              
                              
                              
                              1,102
                              
                              
                              
                              
                              
                              
                              
                              1,102Unrealized
      security holding loss (net of $463 tax benefit)
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              (663
                              )
                              
                              
                              
                              
                              
                              
                              (663
                              )
                              
                              
                              (663
                              )Realized
      gains on sale of securities (net of $50 tax)
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              72
                              
                              
                              
                              
                              
                              
                              
                              72
                              
                              
                              
                              72Total
      comprehensive income
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              
                              $
                              511Balance,
      March 31, 2009
                              
                              $
                              19,163
                              
                              
                              
                              7,751,766
                              
                              
                              $
                              48,649
                              
                              
                              $
                              2,993
                              
                              
                              
                              
                              
                              
                              $
                              22,511
                              
                              
                              $
                              (1,683
                              )
                              
                              $
                              91,633





See notes
to condensed consolidated financial statements.







Heritage
Oaks Bancorp | - 6 -


Heritage
Oaks Bancorp


and
Subsidiaries


Consolidated
Statements of Cash Flows





For the three month periodsendedMarch31,(dollars in thousands)
                  
                  2010
                  
                  
                  2009Cash
      flows from operating activities:Net
      (loss) / income
                  
                  $
                  (1,339
                  )
                  
                  $
                  1,102Adjustments
      to reconcile net income to net cash provided by operating
      activities:Depreciation
      and amortization
                  
                  
                  319
                  
                  
                  
                  270Provision
      for possible loan losses
                  
                  
                  5,200
                  
                  
                  
                  2,110Amortization
      of premiums / discounts on investment securities, net
                  
                  
                  183
                  
                  
                  
                  (32
                  )Amortization
      of intangible assets
                  
                  
                  129
                  
                  
                  
                  263Share-based
      compensation expense
                  
                  
                  99
                  
                  
                  
                  90Gain
      on sale of available for sale securities
                  
                  
                  -
                  
                  
                  
                  (122
                  )Decrease
      / (increase) in loans held for sale
                  
                  
                  1,672
                  
                  
                  
                  (5,867
                  )Net
      increase in bank owned life insurance
                  
                  
                  (135
                  )
                  
                  
                  (105
                  )(Increase)
      / decrease in deferred tax asset
                  
                  
                  (1,515
                  )
                  
                  
                  6Loss
      on sale and write-downs on other real estate owned
                  
                  
                  205
                  
                  
                  
                  101Decrease
      / (increase) in other assets
                  
                  
                  1,430
                  
                  
                  
                  (651
                  )Increase
      in other liabilities
                  
                  
                  417
                  
                  
                  
                  655NET
      CASH PROVIDED / (USED) IN OPERATING ACTIVITIES
                  
                  
                  6,665
                  
                  
                  
                  (2,180
                  )Cash
      flows from investing activities:Purchase
      of securities, available for sale
                  
                  
                  (10,492
                  )
                  
                  
                  (20,539
                  )Sale
      of available for sale securities
                  
                  
                  -
                  
                  
                  
                  4,762Maturities
      and calls of available for sale securities
                  
                  
                  3
                  
                  
                  
                  610Proceeds
      from principal reductions and maturitiesof
      available for sale securities
                  
                  
                  4,105
                  
                  
                  
                  2,478Purchase
      of Federal Home Loan Bank stock
                  
                  
                  -
                  
                  
                  
                  (705
                  )Decrease
      / (increase) in loans, net
                  
                  
                  4,300
                  
                  
                  
                  (13,736
                  )Allowance
      for loan and lease loss recoveries
                  
                  
                  497
                  
                  
                  
                  3Purchase
      of property, premises and equipment, net
                  
                  
                  (36
                  )
                  
                  
                  (282
                  )Proceeds
      from sale of other real estate owned
                  
                  
                  -
                  
                  
                  
                  87NET
      CASH (USED) IN INVESTING ACTIVITIES
                  
                  
                  (1,623
                  )
                  
                  
                  (27,322
                  )Cash
      flows from financing activities:Increase
      in deposits, net
                  
                  
                  19,951
                  
                  
                  
                  61,300Proceeds
      from Federal Home Loan Bank borrowing
                  
                  
                  35,000
                  
                  
                  
                  35,000Repayments
      of Federal Home Loan Bank borrowing
                  
                  
                  (35,000
                  )
                  
                  
                  (49,000
                  )Decrease
      in repurchase agreements
                  
                  
                  -
                  
                  
                  
                  (2,796
                  )Increase
      in secured borrowings
                  
                  
                  2,479
                  
                  
                  
                  -Proceeds
      from exercise of stock options
                  
                  
                  42
                  
                  
                  
                  -Cash
      dividends paid
                  
                  
                  (262
                  )
                  
                  
                  -Proceeds
      from issuance of preferred stock and common stock warrants,
      net
                  
                  
                  52,335
                  
                  
                  
                  21,000NET
      CASH PROVIDED BY FINANCING ACTIVITIES
                  
                  
                  74,545
                  
                  
                  
                  65,504Net
      increase in cash and cash equivalents
                  
                  
                  79,587
                  
                  
                  
                  36,002Cash
      and cash equivalents, beginning of period
                  
                  
                  40,738
                  
                  
                  
                  24,571Cash
      and cash equivalents, end of period
                  
                  $
                  120,325
                  
                  
                  $
                  60,573Supplemental
      Cash Flow Disclosures:Cash
      Flow informationInterest
      paid
                  
                  $
                  2,547
                  
                  
                  $
                  2,483Income
      taxes paid
                  
                  $
                  -
                  
                  
                  $
                  -Non-Cash
      Flow InformationChange
      in other valuation allowance for investment securities
                  
                  $
                  1,007
                  
                  
                  $
                  (1,004
                  )Loans
      transferred to OREO or foreclosed collateral
                  
                  $
                  -
                  
                  
                  $
                  1,748





See notes
to condensed consolidated financial statements.







Heritage
Oaks Bancorp | - 7 -




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 Bank (“the
Bank”).  All significant inter-company balances and transactions have
been eliminated. Heritage Oaks Capital Trusts II and III are unconsolidated
subsidiaries formed solely for the purpose of issuing trust preferred
securities. Operating results for the three months ended March 31, 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 months ended March 31, 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 March
31, 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 period
ended March 31, 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 March 31, 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 | - 8 -




Notes to
Consolidated Financial Statements





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





(dollars in thousands)
                          
                          
                          
                          
                          Gross
                          
                          
                          GrossAmortized
                          
                          
                          Unrealized
                          
                          
                          Unrealized
                          
                          
                          FairAs of March 31, 2010
                          
                          Cost
                          
                          
                          Gains
                          
                          
                          Losses
                          
                          
                          ValueObligations
      of U.S. government agencies
                          
                          $
                          106
                          
                          
                          $
                          -
                          
                          
                          $
                          (4
                          )
                          
                          $
                          102Mortgage
      backed securities
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          -Agency
                          
                          
                          85,330
                          
                          
                          
                          864
                          
                          
                          
                          (518
                          )
                          
                          
                          85,676Non-agency
                          
                          
                          20,962
                          
                          
                          
                          1,152
                          
                          
                          
                          (2,570
                          )
                          
                          
                          19,544Obligations
      of state and political subdivisions
                          
                          
                          22,702
                          
                          
                          
                          433
                          
                          
                          
                          (178
                          )
                          
                          
                          22,957Other
      securities
                          
                          
                          109
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          109Total
                          
                          $
                          129,209
                          
                          
                          $
                          2,449
                          
                          
                          $
                          (3,270
                          )
                          
                          $
                          128,388As
      of December 31, 2009Obligations
      of U.S. government agencies
                          
                          $
                          108
                          
                          
                          $
                          -
                          
                          
                          $
                          (4
                          )
                          
                          $
                          104Mortgage
      backed securitiesAgency
                          
                          
                          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 three months ended March 31, 2010 the Bank purchased approximately $10.5
million in investment securities and made no sales of investment securities
during this period.  Sales of investment securities during the first
three months of 2009 totaled approximately $4.8 million.  Gains
recognized in connection with those sales totaled approximately $0.1
million.





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 Bank to hold such
securities for a period of time sufficient to allow for any anticipated recovery
in fair value and (6) in the case of mortgage related securities, credit
enhancements, loan-to-values, credit scores, delinquency and default rates, cash
flows and the extent to which those cash flows are within Management’s initial
expectations based on pre-purchase analyses.





During
the fourth quarter of 2009 the Company performed an analysis, with the
assistance of an independent third party, on several non-agency whole loan CMOs
in the investment portfolio for other than temporary impairment
(“OTTI”).  These securities were in a net unrealized loss position for
more than 12 months, were downgraded to below investment grade status, and had
been experiencing increases in delinquency and default rates for a period of at
least 12 months.  The Company’s review of these securities was
performed under FASB ASC 320, which includes new guidance the Company was
required to adopt on January 1, 2009 in evaluating investments for other than
temporary impairment.  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.





Under
FASB ASC 320, an OTTI loss must be fully recognized in earnings if an investor
has the intent to sell the security or if it is more likely than not the
investor will be required to sell the security before the recovery of its
amortized cost.  However, if an investor 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.





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







Heritage
Oaks Bancorp | - 9 -




Notes to
Consolidated Financial Statements





The
results of the Company’s evaluation of several non-agency whole loan CMOs
indicated there was OTTI on four holdings in the investment portfolio as of
December 31, 2009.  The gross unrealized loss on these holdings at the
time impairment was determined was approximately $2.0 million.  The
Company’s analysis indicated that approximately $0.4 million of these losses
were credit related, while approximately $1.6 million were related to all other
factors, including general market conditions.  These amounts were
recorded in the Company’s consolidated financial statements during the fourth
quarter of 2009.  As of March 31, 2010 the remaining book balance of
these securities was approximately $5.2 million, compared to the $5.4 million
reported at December 31, 2009. In the first quarter of 2010, the Company engaged
an independent third party to review these same securities for additional
OTTI.  The results of that analysis indicated there was no additional
OTTI on these securities.  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 credit loss.





As of
March 31, 2010, unrealized losses on other non-agency CMOs within the Bank’s
investment portfolio were primarily attributable to market interest rate
volatility and a significant widening of interest rate spreads across market
sectors relating to the continued illiquidity and 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 March 31, 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 illiquidity in the
financial markets.





As of
March 31, 2010, the Company believes that unrealized losses on agency mortgage
related 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 March 31, 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 March 31, 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.  The Company did not record any OTTI on investment
securities during the three months ended March 31, 2010.





OTTI RelatedOTTI Related
                  
                  
                  All Other
                  
                  
                  Total(dollar amounts in thousands)
                  
                  to Credit Loss
                  
                  
                  Factors
                  
                  
                  OTTIBalance,
      December 31, 2009
                  
                  $
                  (372
                  )
                  
                  $
                  (1,584
                  )
                  
                  $
                  (1,956
                  )Charges
      on securities for which OTTI was not previously recognized
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -Balance,
      March 31, 2010
                  
                  $
                  (372
                  )
                  
                  $
                  (1,584
                  )
                  
                  $
                  (1,956
                  )







Heritage
Oaks Bancorp | - 10 -




Notes to
Consolidated Financial Statements





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





Securities In A Loss PositionFor Less Than 12 Months
                          
                          
                          For 12 Months or More
                          
                          
                          Total(dollar amounts in thousands)
                          
                          Fair
                          
                          
                          Unrealized
                          
                          
                          Fair
                          
                          
                          Unrealized
                          
                          
                          Fair
                          
                          
                          UnrealizedAs of March 31, 2010
                          
                          Value
                          
                          
                          Loss
                          
                          
                          Value
                          
                          
                          Loss
                          
                          
                          Value
                          
                          
                          LossObligations
      of U.S. government agencies
                          
                          $
                          -
                          
                          
                          $
                          -
                          
                          
                          $
                          102
                          
                          
                          $
                          (4
                          )
                          
                          $
                          102
                          
                          
                          $
                          (4
                          )Mortgage
      backed securitiesAgency
                          
                          
                          32,376
                          
                          
                          
                          (516
                          )
                          
                          
                          306
                          
                          
                          
                          (2
                          )
                          
                          
                          32,682
                          
                          
                          
                          (518
                          )Non-agency
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          11,364
                          
                          
                          
                          (2,570
                          )
                          
                          
                          11,364
                          
                          
                          
                          (2,570
                          )Obligations
      of state and political subdivisions
                          
                          
                          6,171
                          
                          
                          
                          (178
                          )
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          6,171
                          
                          
                          
                          (178
                          )Total
                          
                          $
                          38,547
                          
                          
                          $
                          (694
                          )
                          
                          $
                          11,772
                          
                          
                          $
                          (2,576
                          )
                          
                          $
                          50,319
                          
                          
                          $
                          (3,270
                          )As of December 31, 2009Obligations
      of U.S. government agencies
                          
                          $
                          -
                          
                          
                          $
                          -
                          
                          
                          $
                          104
                          
                          
                          $
                          (4
                          )
                          
                          $
                          104
                          
                          
                          $
                          (4
                          )Mortgage
      backed securitiesAgency
                          
                          
                          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 March
31, 2010, the Bank owned eleven Whole Loan Private Label Mortgage Backed
Securities (“PMBS”) with a remaining principal balance of approximately $19.5
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 Bank owns with the exception of one mezzanine bond
(subordinate).  At March 31, 2010, six bonds in the approximate amount
of $11.1 million, were reassessed by one or more of the rating agencies (the
Bank must use the most recent and lowest rating when there are discrepancies
between the agencies) and subsequently downgraded below investment
grade.  All six of these bonds are in senior or super senior tranche
positions of their respective deals, meaning the Bank has priority in cash flows
and has subordinate tranches below its position providing credit
support.





The Bank
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 March 31, 2010, Management does not
believe that losses on PMBS in the portfolio, other than those previously
discussed, are other than temporary.







Heritage
Oaks Bancorp | - 11 -




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 March 31,
2010 compared to December 31, 2009:





March 31,
                  
                  
                  December 31,(dollars in thousands)
                  
                  2010
                  
                  
                  2009Real
      Estate SecuredMulti-family
      residential
                  
                  $
                  20,530
                  
                  
                  $
                  20,631Residential
      1 to 4 family
                  
                  
                  25,846
                  
                  
                  
                  25,483Home
      equity lines of credit
                  
                  
                  29,383
                  
                  
                  
                  29,780Commercial
                  
                  
                  335,733
                  
                  
                  
                  337,940Farmland
                  
                  
                  12,804
                  
                  
                  
                  13,079CommercialCommercial
      and industrial
                  
                  
                  152,291
                  
                  
                  
                  157,270Agriculture
                  
                  
                  19,591
                  
                  
                  
                  17,698Other
                  
                  
                  238
                  
                  
                  
                  238ConstructionSingle
      family residential
                  
                  
                  15,732
                  
                  
                  
                  15,538Single
      family residential - Spec.
                  
                  
                  3,295
                  
                  
                  
                  3,400Tract
                  
                  
                  1,245
                  
                  
                  
                  2,215Multi-family
                  
                  
                  1,883
                  
                  
                  
                  2,300Hospitality
                  
                  
                  13,126
                  
                  
                  
                  14,306Commercial
                  
                  
                  30,704
                  
                  
                  
                  27,128Land
                  
                  
                  51,557
                  
                  
                  
                  52,793Installment
      loans to individuals
                  
                  
                  8,407
                  
                  
                  
                  8,327All
      other loans (including overdrafts)
                  
                  
                  378
                  
                  
                  
                  553Total
      loans, gross
                  
                  
                  722,743
                  
                  
                  
                  728,679Deferred
      loan fees
                  
                  
                  1,699
                  
                  
                  
                  1,825Reserve
      for possible loan losses
                  
                  
                  18,559
                  
                  
                  
                  14,372Total
      loans, net
                  
                  $
                  702,485
                  
                  
                  $
                  712,482Loans
      held for sale
                  
                  $
                  7,815
                  
                  
                  $
                  9,487





Concentration
of Credit Risk





At March
31, 2010, approximately $541.8 million or 75.0% of the Bank’s loan portfolio was
collateralized by various forms of real estate, this represents a decrease of
approximately $2.8 million when compared to the $544.6 million or 74.7% reported
at December 31, 2009.  Such loans are generally made to borrowers
located in San Luis Obispo and Santa Barbara Counties. The Bank attempts to
reduce its concentration of credit risk by making loans which are diversified by
industry and project type.  While Management believes that the
collateral presently securing this portfolio is adequate, there can be no
assurances that further significant deterioration in the California real estate
market would not expose the Bank to significantly greater credit
risk.





At March
31, 2010, the Bank was contingently liable for letters of credit accommodations
made to its customers totaling approximately $17.1 million and un-disbursed loan
commitments in the approximate amount of $131.1 million. The Bank makes
commitments to extend credit in the normal course of business to meet the
financing needs of its customers. Commitments to extend credit are agreements to
lend to a customer as long as there is no violation of any condition established
in the contract.  Commitments generally have fixed expiration dates or
other termination clauses and may require payment of a fee.  Since
many of the commitments are expected to expire without being drawn upon, the
total outstanding commitment amount does not necessarily represent future cash
requirements. Standby letters of credit written are conditional commitments
issued by the Bank to guarantee the performance of a customer to a third party.
The credit risk involved in issuing letters of credit is essentially the same as
those involved in extending loan facilities to customers. The Bank 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 | - 12 -




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 $16.2 million and
$16.3 million at March 31, 2010 and December 31, 2009,
respectively.





The Bank
also originates SBA loans for sale to governmental agencies and institutional
investors.  At March 31, 2010 and December 31, 2009, the unpaid
principal balance of SBA loans serviced for others totaled $4.3 million and $4.4
million, respectively.  The Bank booked approximately $48 thousand in
servicing assets related to the sale of SBA loans in the first quarter of 2010,
which will be amortized in proportion to and over the period of estimated net
servicing income associated with each SBA loan for which the Bank provides
servicing.





The
following table provides a reconciliation of the change in net SBA servicing
assets for the three months ended March 31, 2010:





For the three months ended,(dollar amounts in thousands)
                  
                  March 31, 2010Beginning
      balance
                  
                  $
                  (19
                  )Additions
                  
                  
                  48Disposals
                  
                  
                  -Amortzation
                  
                  
                  -Ending
      balance
                  
                  $
                  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 in ASC
860.





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 Bank would continue to account for the transfer
as secured borrowing.





The
accounting guidance provided under ASC 860 has impacted the way the Bank
accounts for the sale of SBA loans.  The terms contained in certain
participation and loan sale agreements, specifically those that related 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 Bank 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 reevaluated to determine if they meet the
participating interest definition and subsequently accounted for as a
sale.  As a result, the Bank 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 | - 13 -




Notes to
Consolidated Financial Statements





Impaired
Loans





The
following provides a summary of the Bank’s investment in impaired loans, the
corresponding valuation allowance for such loans, and income recognized thereon
as of March 31, 2010 and 2009:





March 31,
                  
                  
                  December 31,(dollar amounts in
    thousands)
                  
                  2010
                  
                  
                  2009Non-accruing
      loans
                  
                  $
                  48,983
                  
                  
                  $
                  38,170Loans
      90 days or more past due
                  
                  
                  -
                  
                  
                  
                  151Troubled
      debt restructures
                  
                  
                  7,429
                  
                  
                  
                  9,703Total
      impaired loans
                  
                  $
                  56,412
                  
                  
                  $
                  48,024Impaired
      loans with a valuation allowance
                  
                  $
                  22,378
                  
                  
                  $
                  6,155Valuation
      allowance related to impaired loans
                  
                  $
                  4,094
                  
                  
                  $
                  852Impaired
      loans without a valuation allowance
                  
                  $
                  34,034
                  
                  
                  $
                  41,869Average
      recorded investment in impaired loans
                  
                  $
                  49,779
                  
                  
                  $
                  32,781Cash
      receipts applied to reduce principal balance
                  
                  $
                  2,516
                  
                  
                  $
                  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 the loans currently identified as impaired
have unique risk characteristics, valuation allowances the Bank has recorded
were determined on a loan-by-loan basis.





Loans the
Company considers to be impaired totaled approximately $56.4 million and $48.0
million at March 31, 2010 and December 31, 2009, respectively.  The
Company classifies all non-accruing loans as well as loans 90 days or more past
due and still accruing as impaired.  If interest on non-accruing loans
had been recognized at the original interest rates stipulated in the respective
loan agreements, interest income would have increased $0.6 million during the
first three months of 2010.  The Company recognized approximately $0.1
million and $4 thousand in interest income certain loans classified as impaired
for the three months ended March 31, 2010 and 2009, respectively.  It
should be noted that a significant portion of the Company’s impaired loans were
carried at fair value as of March 31, 2010, resulting in large part from the
charge-off of loan balances following the receipt of appraisal information on
the underlying collateral.





At March
31, 2010, approximately $14.2 million in loans were classified as troubled debt
restructurings (“TDRs”) of which approximately $6.8 million were non-accruing
and approximately $7.4 million were accruing.  As of March 31, 2010
substantially all TDRs were evaluated based on the underlying collateral of the
respective loans.  In a majority of cases, the Company has granted
concessions regarding interest rates, payment structure and
maturity.  Foregone interest related to TDRs totaled approximately $42
thousand and $2 thousand for the three months ended March 31, 2010 and 2009,
respectively.





Allowance
for Loan Losses





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







Heritage
Oaks Bancorp | - 14 -




Notes to
Consolidated Financial Statements





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 year endedMarch 31,
                        
                        
                        December 31,(dollars in thousands)
                        
                        2010
                        
                        
                        2009
                        
                        
                        2009Balance
      at beginning of period
                        
                        $
                        14,372
                        
                        
                        $
                        10,412
                        
                        
                        $
                        10,412Provision
      expense
                        
                        
                        5,200
                        
                        
                        
                        2,110
                        
                        
                        
                        24,066Loans
      charged-offCommercial
      real estate
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        339Residential
      1-4 family
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        558Commercial
      and industrial
                        
                        
                        949
                        
                        
                        
                        283
                        
                        
                        
                        5,816Agriculture
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        2,224Construction
                        
                        
                        463
                        
                        
                        
                        1,406
                        
                        
                        
                        2,218Land
                        
                        
                        -
                        
                        
                        
                        310
                        
                        
                        
                        8,886Other
                        
                        
                        98
                        
                        
                        
                        97
                        
                        
                        
                        163Total
      charge-offs
                        
                        
                        1,510
                        
                        
                        
                        2,096
                        
                        
                        
                        20,204Recoveries
      of loans previously charged off
                        
                        
                        497
                        
                        
                        
                        3
                        
                        
                        
                        98Balance
      at end of period
                        
                        $
                        18,559
                        
                        
                        $
                        10,429
                        
                        
                        $
                        14,372





During
the three months ended March 31, 2010, the Company made provisions for loan
losses in the amount of $5.2 million. This when compared to the $2.1 million
reported for the same period ended a year earlier, represents an increase of
approximately $3.1 million.  Elevated provision expenses are
reflective of, among other things, additional loan balances charged-off during
the first three 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 the same period ended in 2009 and the
downgrade of certain credits within the loan portfolio.





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





The
following table provides a summary of the change in the balance of OREO for the
periods indicated below:





For the three months ended
                    
                    
                    For the year endedMarch 31,
                    
                    
                    December 31,(dollar amounts in
    thousands)
                    
                    2010
                    
                    
                    2009
                    
                    
                    2009Beginning
      balance
                    
                    $
                    946
                    
                    
                    $
                    1,337
                    
                    
                    $
                    1,337Additions
                    
                    
                    -
                    
                    
                    
                    1,748
                    
                    
                    
                    9,595Dispositions
                    
                    
                    -
                    
                    
                    
                    (119
                    )
                    
                    
                    (8,521
                    )Write-downs
                    
                    
                    (205
                    )
                    
                    
                    (73
                    )
                    
                    
                    (1,465
                    )Ending
      balance
                    
                    $
                    741
                    
                    
                    $
                    2,893
                    
                    
                    $
                    946





Note
5.  Deferred Tax Assets





The
Company is permitted to recognize deferred tax assets (“DTA”) only to the extent
that they are expected to be used to reduce amounts that have been paid or will
be paid to tax authorities.  The determination of the amount of DTA
which is more likely than not to be realized is primarily dependent on
projections of future earnings, which are subject to uncertainty and estimates
that may change given economic conditions and other factors.  The
realization of the DTA is assessed by the Company periodically.  If
the Company determines that there is not sufficient positive evidence to support
the realization of its DTA beyond what it can realize from the carry-back of
operating losses a valuation allowance is established for all or a portion of
the DTA it expects will not be realized.





In the
fourth quarter of 2009, the Company performed an in depth analysis of its DTA to
determine if the current carrying value of the DTA would be realized in future
periods.  Based on the Company’s analysis and all currently available
information, the Company believes that as of March 31, 2010 the carrying value
of the DTA can be supported and that a valuation allowance is not necessary at
this time.







Heritage
Oaks Bancorp | - 15 -




Notes to
Consolidated Financial Statements





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 our 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
our common stock and our TARP preferred stock immediately before the ownership
change.  Our 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 our
assets immediately prior to the ownership change.





Because
the amount of equity issued in the Company’s March 2010 private placement
triggered an ownership change under Section 382, our 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. The Company has not yet
determined the impact this will have on its financial statements.





Note
6.  Earnings / (Loss) Per Share





Basic
earnings / (loss) per common share are computed by dividing net income available
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 as well as the mandatorily convertible preferred stock issued in the
Company’s March 2010 private placement, as more fully discussed under Note 10.
Preferred Stock of these consolidated financial statements.  U.S. GAAP
prohibits the computation of diluted earnings / (loss) per share from assuming
exercise or issuance of securities that would have an anti dilutive effect on
earnings per share.  As a result, the outstanding shares from the
potential exercise of share-based compensation awards, the warrant issued to the
U.S. Treasury and the dilutive impact of the preferred stock issued in the
Company’s March 2010 private placement were not included in the calculation of
diluted earnings / (loss) per share for the three months ended March 31,
2010.





The
following table sets forth the number of shares used in the calculation of both
basic and diluted earnings / (loss) per share for the three months ended March
31, 2010 and 2009:





For the three months
ending,March 31, 2010
                                                    
                                                    
                                                    March 31, 2009Net
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    Net(dollar amounts in thousands except per share
      data)
                                                    
                                                    Income
                                                    
                                                    
                                                    Shares
                                                    
                                                    
                                                    Income
                                                    
                                                    
                                                    SharesNet
      (loss) / income
                                                    
                                                    $
                                                    (1,339
                                                    )
                                                    
                                                    
                                                    
                                                    
                                                    $
                                                    1,102Dividends
      and accretion on preferred stock
                                                    
                                                    
                                                    351
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    11Net
      (loss) / income available to common shareholders
                                                    
                                                    $
                                                    (1,690
                                                    )
                                                    
                                                    
                                                    
                                                    
                                                    $
                                                    1,091Weighted
      average shares outstanding
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    7,717,194
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    7,689,317Basic
      (loss) / earnings per common share
                                                    
                                                    $
                                                    (0.22
                                                    )
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    $
                                                    0.14Dilutive
      effect of share-based compensation awards
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    135,060Dilutive
      effect of common stock warrant
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    -Dilutive
      effect of mandatorily convertible preferred stock
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    -Weighted
      average diluted shares outstanding
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    7,717,194
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    7,824,377Diluted
      (loss) / earnings per common share
                                                    
                                                    $
                                                    (0.22
                                                    )
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    $
                                                    0.14


Heritage
Oaks Bancorp | - 16 -







Notes to
Consolidated Financial Statements





Note
7.  Recent Accounting Pronouncements





In
February 2010, the Financial Accounting Standards Board (“FASB”) issued Accounting
Standards Update (“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.





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 Amendmentof 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 does not currently believe the
impact of adoption will have 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.







Heritage
Oaks Bancorp | - 17 -




Notes to
Consolidated 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 is adopted this accounting standard on January 1,
2010.  The adoption of this standard did not have a material impact on
its financial statements.





Note
8.  Share-Based Compensation





As of
March 31, 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 either the fair market value
per share or book value per share (corresponding to the type of stock awarded)
as of the grant date.  For stock option awards, the grant date fair
value is estimated using the Black-Scholes option pricing model. For all awards,
the Company recognizes these compensation costs only for those shares expected
to vest on a straight-line basis over the requisite service period of the award,
for which we use the related vesting term.  The Company estimates
forfeiture rates based on historical employee option exercise and employee
termination experience.





The
share-based compensation expense recognized in the consolidated statements of
income for the three months ended March 31, 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 endedMarch 31,(dollars in thousands except share and per share
      data)
                    
                    2010
                    
                    
                    2009Share-based
      compensation expenseStock
      option expense
                    
                    $
                    47
                    
                    
                    $
                    44Restricted
      stock expense
                    
                    
                    52
                    
                    
                    
                    46Total
      share-based compensation expense
                    
                    $
                    99
                    
                    
                    $
                    90Total
      share-based compensation expense, net of tax
                    
                    $
                    63
                    
                    
                    $
                    56Diluted
      shares outstanding
                    
                    
                    7,717,194
                    
                    
                    
                    7,824,377Impact
      on diluted earnings per share
                    
                    $
                    -
                    
                    
                    $
                    0.007Unrecognized
      compensation expenseStock
      option expense
                    
                    $
                    203
                    
                    
                    $
                    279Restricted
      stock expense
                    
                    
                    186
                    
                    
                    
                    425Total
      unrecognized share-based compensation expense
                    
                    $
                    389
                    
                    
                    $
                    704Total
      unrecognized share-based compensation expense, net of tax
                    
                    $
                    265
                    
                    
                    $
                    420







Heritage
Oaks Bancorp | - 18 -




Notes to
Consolidated Financial Statements





At March
31, 2010, there was a total of $203 thousand of unrecognized compensation
expense related to non-vested stock option awards. That expense is expected to
be recognized over a weighted-average period of 1.6 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 March 31, 2010 was $186 thousand.
That expense is expected to be recognized over the next 12 months.





The
aggregate intrinsic value in the table below represents the total pretax
intrinsic value (the difference between the Company’s closing stock price on the
last trading day of the first 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 March 31,
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 for the
three month period ended March 31, 2010.  There were no option
exercises in the first quarter of 2009.





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 March 31, 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
                    
                    
                    $
                    9.15Exercised
                    
                    
                    (11,260
                    )
                    
                    
                    3.73Options
      outstanding, March 31, 2010
                    
                    
                    429,478
                    
                    
                    $
                    9.29
                    
                    
                    
                    4.20
                    
                    
                    $
                    5Exercisable
      at March 31, 2010
                    
                    
                    352,153
                    
                    
                    $
                    9.54
                    
                    
                    
                    3.23
                    
                    
                    $
                    5Options
      outstanding, January 1, 2009
                    
                    
                    408,830
                    
                    
                    $
                    9.34Granted
                    
                    
                    25,000
                    
                    
                    
                    4.50Options
      outstanding, March 31, 2009
                    
                    
                    433,830
                    
                    
                    $
                    9.06
                    
                    
                    
                    4.43
                    
                    
                    $
                    31Exercisable
      at March 31, 2009
                    
                    
                    354,033
                    
                    
                    $
                    8.74
                    
                    
                    
                    3.44
                    
                    
                    $
                    31





The
Company did not grant any options during the three months ended March 31,
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 following table presents the assumptions used in the
calculation of the weighted average fair value of options granted during the
first quarter of 2009:





2009Expected
      volatility
                      
                      
                      41.61
                      %Expected
      term (years)
                      
                      
                      10Dividend
      yield
                      
                      
                      0.00
                      %Risk
      free rate
                      
                      
                      2.76
                      %Weighted-average
      grant date fair value
                      
                      $
                      2.52





The table
above 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.







Heritage
Oaks Bancorp | - 19 -




Notes to
Consolidated Financial Statements





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.





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 March 31, 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 | - 20 -




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.  When appraised values are not available, there is no observable
market price for similar assets, or Management determines the fair value of the
asset is further impaired below appraised values or observable market prices,
the Company records other real estate owned or foreclosed collateral as
non-recurring Level 3.





The
following table provides a summary of the financial instruments the Company
measures at fair value on a recurring basis as of March 31, 2010:





Fair Value Measurements UsingQuoted Prices in
                        
                        
                        Significant Other
                        
                        
                        SignificantActive Markets for
                        
                        
                        Observable
                        
                        
                        Unobservable(dollars in thousands)
                        
                        Identical Assets
                        
                        
                        Inputs
                        
                        
                        Inputs
                        
                        
                        Assets AtAs of March 31, 2010
                        
                        (Level 1)
                        
                        
                        (Level 2)
                        
                        
                        (Level 3)
                        
                        
                        Fair ValueAssetsObligations
      of U.S. government agencies
                        
                        $
                        -
                        
                        
                        $
                        102
                        
                        
                        $
                        -
                        
                        
                        $
                        102Mortgage
      backed securitiesAgency
                        
                        
                        -
                        
                        
                        
                        85,676
                        
                        
                        
                        -
                        
                        
                        
                        85,676Non-agency
                        
                        
                        -
                        
                        
                        
                        19,544
                        
                        
                        
                        -
                        
                        
                        
                        19,544Obligations
      of state and political subdivisions
                        
                        
                        -
                        
                        
                        
                        22,223
                        
                        
                        
                        734
                        
                        
                        
                        22,957Other
      securities
                        
                        
                        -
                        
                        
                        
                        109
                        
                        
                        
                        -
                        
                        
                        
                        109Total
      assets measured on a recurring basis
                        
                        $
                        -
                        
                        
                        $
                        127,654
                        
                        
                        $
                        734
                        
                        
                        $
                        128,388As 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 three months
ended March 31, 2010:





Purchases,Balance as of
                
                
                Gains / (Losses)
                
                
                Issuances, and
                
                
                Balance as of(dollars in thousands)
                
                December 31, 2009
                
                
                Included in OCI (1)
                
                
                Settlements
                
                
                March 31, 2010Obligations
      of state and political subdivisions
                
                $
                737
                
                
                $
                (3
                )
                
                $
                -
                
                
                $
                734





(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 | - 21 -




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 March 31,
2010:


Fair Value Measurements UsingQuoted Prices in
                        
                        
                        SignificantOther
                        
                        
                        SignificantActive Markets for
                        
                        
                        Observable
                        
                        
                        Unobservable(dollars in thousands)
                        
                        Identical Assets
                        
                        
                        Inputs
                        
                        
                        Inputs
                        
                        
                        Assets At
                        
                        
                        TotalAs of March 31, 2010
                        
                        (Level 1)
                        
                        
                        (Level 2)
                        
                        
                        (Level 3)
                        
                        
                        Fair Value
                        
                        
                        Gains (Losses)AssetsImpaired
      loans
                        
                        $
                        -
                        
                        
                        $
                        52,318
                        
                        
                        $
                        -
                        
                        
                        $
                        52,318
                        
                        
                        $
                        (1,510
                        )Loans
      held for sale
                        
                        
                        -
                        
                        
                        
                        7,815
                        
                        
                        
                        -
                        
                        
                        
                        7,815
                        
                        
                        
                        -Other
      real estate owned
                        
                        
                        -
                        
                        
                        
                        741
                        
                        
                        
                        -
                        
                        
                        
                        741
                        
                        
                        
                        (205
                        )Goodwill
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        11,049
                        
                        
                        
                        11,049
                        
                        
                        
                        -Total
      assets measured on a non-recurring basis
                        
                        $
                        -
                        
                        
                        $
                        60,874
                        
                        
                        $
                        11,049
                        
                        
                        $
                        71,923
                        
                        
                        $
                        (1,715
                        )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.  Additionally, the Company has certain other loans that
are measured at fair value on a non-recurring basis such as loans that were
acquired in the acquisition of Business First National Bank.





Note
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 | - 22 -




Notes to
Consolidated Financial Statements





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





March 31, 2010
                              
                              
                              December 31, 2009Carrying
                              
                              
                              
                              
                              
                              Carrying(dollars in thousands)
                              
                              Amount
                              
                              
                              Fair Value
                              
                              
                              Amount
                              
                              
                              Fair ValueAssetsCash
      and cash equivalents
                              
                              $
                              120,325
                              
                              
                              $
                              120,325
                              
                              
                              $
                              40,738
                              
                              
                              $
                              40,738Interest
      bearing deposits
                              
                              
                              119
                              
                              
                              
                              119
                              
                              
                              
                              119
                              
                              
                              
                              119Investments
      and mortgage-backed securities
                              
                              
                              128,388
                              
                              
                              
                              128,388
                              
                              
                              
                              121,180
                              
                              
                              
                              121,180Federal
      Home Loan Bank stock
                              
                              
                              5,828
                              
                              
                              
                              5,828
                              
                              
                              
                              5,828
                              
                              
                              
                              5,828Loans
      receivable, net of deferred fees and costs
                              
                              
                              721,044
                              
                              
                              
                              722,275
                              
                              
                              
                              726,854
                              
                              
                              
                              731,045Loans
      held for sale
                              
                              
                              7,815
                              
                              
                              
                              7,815
                              
                              
                              
                              9,487
                              
                              
                              
                              9,487Bank
      owned life insurance
                              
                              
                              12,684
                              
                              
                              
                              12,684
                              
                              
                              
                              12,549
                              
                              
                              
                              12,549Accrued
      interest receivable
                              
                              
                              3,489
                              
                              
                              
                              3,489
                              
                              
                              
                              3,639
                              
                              
                              
                              3,639LiabilitiesNon-interest
      bearing deposits
                              
                              
                              178,976
                              
                              
                              
                              178,976
                              
                              
                              
                              174,635
                              
                              
                              
                              174,635Interest
      bearing deposits
                              
                              
                              616,440
                              
                              
                              
                              615,944
                              
                              
                              
                              600,830
                              
                              
                              
                              596,782Federal
      Home Loan Bank advances
                              
                              
                              65,000
                              
                              
                              
                              65,117
                              
                              
                              
                              65,000
                              
                              
                              
                              65,180Junior
      subordinated debentures
                              
                              
                              13,403
                              
                              
                              
                              12,440
                              
                              
                              
                              13,403
                              
                              
                              
                              12,390Other
      secured borrowing
                              
                              
                              2,479
                              
                              
                              
                              2,479
                              
                              
                              
                              -
                              
                              
                              
                              -Accrued
      interest payable
                              
                              
                              546
                              
                              
                              
                              546
                              
                              
                              
                              590
                              
                              
                              
                              590Notional
                              
                              
                              Cost to Cede
                              
                              
                              Notional
                              
                              
                              Cost to CedeAmount
                              
                              
                              or Assume
                              
                              
                              Amount
                              
                              
                              or AssumeOff-balance
      sheet instruments, commitments to extend credit and standby letters of
      credit
                              
                              $
                              148,209
                              
                              
                              $
                              1,482
                              
                              
                              $
                              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.





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 | - 23 -




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 anytime.  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 March 31, 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 will accrete the discount on the Series A
Senior Preferred Stock over a period of five years with corresponding charges to
retained earnings.







Heritage
Oaks Bancorp | - 24 -




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 paid
from retained earnings on the Series A Senior Preferred Stock.  For
the three months ended March 31, 2010, dividends and accretion on the Series A
Senior Preferred Stock totaled approximately $0.4
million.  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”).





March
2010 Private Placement





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, 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, pending receipt of
regulatory approvals required for the particular investor purchasing such
shares.





The
following provides a general summary of the private placement as well the terms
of the preferred stock issued and is qualified in its entirety by reference to
the Company’s current report filed on Form 8-K with the SEC on March 10,
2010:





·
            Issued
      an aggregate of 52,088 shares of Series B Preferred Stock with a
      liquidation preference of $1,000 per share with an additional 4,072 shares
      subject to issuance upon the closing of the escrow discussed
      above.





·
            Issued
      1,189,538 shares of Series C Preferred Stock at a price of $3.25 per
      share.





·
            Gross
      proceeds from the offering totaled approximately $60.0 million, assuming
      the successful closing of the escrow for the second closing mentioned
      above.





·
            Series
      B Preferred Stock will convert to 17,280,000 shares of common stock at a
      conversion price of $3.25 per share upon receipt of shareholder approvals
      (as defined in the Company’s March 10, 2010 8-K filing with the
      SEC).  Each share of Series B Preferred Stock provides for
      cumulative dividends as follows: (i) 10% for a period of six months
      following the issuance, (ii) 15% for the next six months, and (iii) 20%
      thereafter.  If shareholder approvals are received within the
      first six month period, no dividends will be owed or paid on the Series B
      Preferred Stock.  If shareholder approval is not received in the
      first six month period, the conversion price will be reduced by
      10%.





·
            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.  Upon receipt of
      shareholder approvals (as defined in the Company’s March 10, 2010 8-K
      filing with the SEC), 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 B Preferred Stock and Series C Preferred Stock will not be redeemable by
either the Company or by the holders.  Holders of the Series B
Preferred Stock and Series C Preferred Stock will not receive 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 applicable series of Preferred
Stock.  However, it should be noted that one investor, currently
seeking regulatory approval to acquire an additional 4,072 shares of Series B
Preferred Stock has Board nomination and observation
rights.  Additionally, one other investor also has Board observation
rights.







Heritage
Oaks Bancorp | - 25 -




Notes to
Consolidated Financial Statements





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 will continue to take all 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, will bring 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. With the capital raise secured, the Company and Bank
believe it can successfully address the requirements of both the Order and the
Written Agreement.





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.  The Bank has taken several steps to comply with the Order, and
importantly recently completed a capital raise as discussed above.  As
mentioned, Management and the Board are aggressively responding to the Order to
ensure full compliance and will continue to take all steps necessary to achieve
such compliance.





·
            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.





·
            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 has been retained to complete the required management
      study, and the Bank intends to comply 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 have agreed to seek regulatory approval to add
      as a director of both the Bank and Company one of the principals of the
      investor in the transaction that proposes to own approximately 14.4% of
      the outstanding voting shares of the Company.  Appropriate
      applications for such approval were submitted on March 26,
      2010.  The addition of a director to the Company’s Board of
      Directors will require an amendment to the Company’s bylaws to increase
      the range of the size of the board.  Such an amendment will
      require the approval of the Company’s shareholders, and such amendment
      will be submitted to the shareholders for approval at the Company’s next
      annual meeting of shareholders.





·
            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.


Heritage
Oaks Bancorp | - 26 -








Notes to
Consolidated Financial Statements





·
            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 is currently in the process of revising 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.





·
            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.  In addition, as of December 31, 2009, and through the date
      of this report, the requirement to reduce assets classified as
      “Substandard” as of the date of the ROE has not been met. However, upon
      the contribution the Company made to the Bank of $48.0 million in proceeds
      from the recent capital raise, the reduction in the percentage of
      “Substandard” assets has been substantially met. The Bank has also
      developed and implemented a process for the review and approval of all
      applicable asset disposition plans.





·
            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.  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.  The Bank is currently in the
      process of developing 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.





·
            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 has since developed a
      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.





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 is currently taking steps to comply 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.


Heritage
Oaks Bancorp | - 27 -








Notes to
Consolidated Financial Statements





Note
13.  Reclassifications





Certain
amounts in the 2009 financial statements have been reclassified to conform to
the 2010 presentation.


Heritage
Oaks Bancorp | - 28 -








Forward
Looking Statements




Certain
statements contained in this Quarterly Report on Form 10-Q (“Quarterly Report”),
including, without limitation, statements containing the words “believes”,
“anticipates”, “intends”, “expects”, and words of similar impact, constitute
“forward-looking statements” within the meaning of Section 27A of the Securities
Act of 1933 and Section 21E of the Securities and Exchange Act of 1934. Such
forward-looking statements involve known and unknown risks, uncertainties and
other factors that may cause the actual results, performance or achievements of
the Company to be materially different from any future results, performance or
achievements expressed or implied by such forward-looking statements. Such
factors include, among others, the following: the ongoing financial crisis in
the United States, and the response of the federal and state government and our
regulators thereto, general economic conditions in those areas in which the
Company operates, the recent fluctuations in U.S. markets resulting, in part,
from problems related to sub-prime lending, the recent downturn in the
California real estate market, general economic and business conditions in those
areas in which the Company operates, demographic changes, competition,
fluctuations in interest rates, changes in business strategy or development
plans, changes in governmental regulation, credit quality, the 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 Bank’s beliefs as to the adequacy of its
existing and anticipated allowance for loan losses, beliefs and expectations
about, and requirements to comply with current regulatory enforcement actions
taken by regulatory authorities having oversight of the Bank’s operations,
financial policies of the United States government and continued weakness in the
real estate markets within which we operate. (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 | - 29 -








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 month periods ending March 31, 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.





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 | - 30 -








Management’s
Discussion and Analysis





Executive
Summary





For the
three months ended March 31, 2010, the Company reported a net loss of
approximately $1.3 million.  In the same period ended a year earlier,
the Company reported net income of approximately $1.1 million.  Net
loss per diluted common share was ($0.22) for the first quarter of 2010,
compared to net income of $0.14 per diluted common share in the same period
ended a year earlier.  Operating results for the first quarter of 2010
were negatively impacted by higher provisions for loan losses when compared to
that reported in the same period a year earlier as well as increased
non-interest expenses. Provisions for loan losses in the first quarter of 2010
totaled $5.2 million, an increase of approximately $3.1 million from that
reported for the same period ended in 2009.  Elevated levels of
substandard and non-performing loans as well as continued weakened economic
conditions contributed to the year over year increase in provisions for loan
losses. Year over year, salaries and benefits increased $0.6 million, regulatory
assessment costs increased $0.5 million and loan department expenses increased
$0.2 million. Aside from an increase in FDIC insurance premiums, increases in
the areas of non-interest expenses mentioned can be associated with the
expansion of the Bank’s management team and special assets department and an
increase in costs associated with managing asset quality
issues.   Increases in these categories of non-interest expense
contributed $1.2 million to the $1.4 million increase for the first quarter of
2010 when compared to that reported for the first quarter of 2009.





Although
the Company reported a net loss for the quarter ended March 31, 2010, the
Company was able to raise $56.0 million in capital through the sale of 52,088
shares of 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.  In addition, approximately
$4.0 million was placed in escrow for a second closing of 4,072 shares of Series
B Preferred Stock, pending receipt of regulatory approvals required for the
particular investor purchasing such shares.  The additional capital
will allow the Company to not only continue to work through asset quality
issues, but will allow the Bank to further focus on building its core
franchise.  For additional information regarding the Company’s March
2010 private placement, please see Note 10. Preferred Stock, of the consolidated
financial statements filed on this Form 10-Q.





Liquidity
remained relatively strong during the first quarter of 2010, with a liquidity
ratio, the ratio of liquid assets not pledged for collateral and other purposes
to deposits and other liabilities, of 30.94% compared to 20.50% reported at
December 31, 2009.  The proceeds from the March 2010 private placement
in conjunction with a $19.9 million or 2.6% increase in total deposits
contributed significantly to the rise in on-balance sheet
liquidity.





The
following provides a summary of operating results for the three month periods
ended March 31, 2010 and 2009:





·
            For
      the three months ended March 31, 2010 interest income totaled
      approximately $12.5 million.  This when compared to the same
      three month period ended a year earlier, represents an increase of
      approximately $0.6 million.  Although the average balance of the
      loan portfolio increased by approximately $36.5 million as of March 31,
      2010 when compared to that reported a year earlier, interest reversals
      associated with non-performing loans as well as the re-pricing and
      pay-down of certain higher yielding credits worked to offset any increase
      in the level of interest and fees earned on loans resulting from year over
      year growth in the loan portfolio.  Interest and fees on loans
      totaled approximately $11.1 million for the three months ended March 31,
      2010, unchanged from that reported a year earlier.  Mitigating
      the impact that interest reversals had in interest income was an
      approximate $0.6 million increase in interest earned in
      investments.  Increases within this category can be attributed
      in large part to the investment of excess liquidity stemming from
      significant year over year deposit
growth.





·
            For
      the three months ended March 31, 2010, interest expense totaled
      approximately $2.5 million.  This when compared to the same
      three month period ended a year earlier, interest expense increased
      approximately $0.2 million.  Although the average rate paid on
      interest bearing deposit balances declined 15 basis points in the first
      quarter of 2010 when compared to that reported in the same year ago
      period, a $139.4 million year over year increase in the average balance of
      interest bearing deposits contributed to the rise in interest expense,
      offsetting the impact of
re-pricings.





·
            Net
      interest income for the three months ended March 31, 2010 totaled
      approximately $9.9 million.  Net interest income increased
      approximately $0.4 million from that reported during the same three month
      period 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 $1.6 million for the three month period ended
      March 31, 2010, representing a decline of approximately $0.1 million when
      compared to the same period ended a year earlier.  The slight
      year over year decline within this category can be attributed to a decline
      in service charge income as well as the absence of a $0.1 million gain on
      sale of investments that occurred in the first quarter of
      2009.  These declines were partially offset by a $49 thousand
      gain recognized on the sale of SBA loans.  For more information
      related to non-interest income, please see “Non-Interest Income” of this
      Discussion and Analysis.


Heritage
Oaks Bancorp | - 31 -








Management’s
Discussion and Analysis





·
            Non-interest
      expense for the first quarter of 2010 totaled approximately $8.9 million,
      an increase of approximately $1.4 million when compared to that reported
      for the same period a year earlier.  As previously mentioned the
      biggest contributors to the year over year increase within this category
      were increased salaries and benefits, higher regulatory assessment costs
      and an increase in costs associated with managing asset quality
      issues.  Partially offsetting these increases was an approximate
      $0.1 million decline in scheduled CDI amortization.  For more
      information related to non-interest expenses, please see “Non-Interest
      Expenses” of this Discussion and
Analysis.





·
            For
      the three months ended March 31, 2010 the Company’s efficiency ratio was
      76.88% compared to the 66.71% reported for the same period ended a year
      earlier. The efficiency ratio was negatively impacted during the first
      quarter primarily by increases in non-interest expenses as discussed in
      the preceding paragraph.  Additionally, interest reversals of
      approximately $0.3 million in the first quarter of 2010 contributed
      further to the increase in the efficiency ratio.  Management
      remains focused on cost controls in an effort to mitigate the rise in
      non-interest expenses primarily resulting from asset quality issues and
      the need to effectively manage them in the current
      environment.





The
following provides a summary for significant year to date changes in financial
condition balances as of March 31, 2010:





·
            At
      March 31, 2010, gross loan balances were approximately $722.7 million,
      approximately $6.0 million or 0.8% lower than the $728.7 million reported
      at December 31, 2009.  The decline in gross loan balances can be
      attributed in large part to several large pay-downs during the first
      quarter 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 certain types of credit as well as the Bank 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
      Bank’s loan portfolio.





·
            At
      March 31, 2010, total deposits were approximately $795.4 million,
      approximately $19.9 million or 2.6% higher than that reported at December
      31, 2009.  Deposits, exclusive of brokered were approximately
      $792.9 million or $28.6 million higher than that reported at December 31,
      2009.  Continued increases in core deposit balances allowed the
      Bank to further pay down brokered deposit balances.  At March
      31, 2010 brokered deposit balances totaled approximately $2.5 million and
      represented 0.3% 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 Bank’s deposit
      liabilities.





·
            At
      March 31, 2010, borrowings with the FHLB were $65.0 million, unchanged
      from that reported at December 31, 2009.  The average rate paid
      on borrowings with the FHLB for the first quarter of 2010 was
      0.57%.





·
            Investment
      securities totaled approximately $128.4 million, approximately $7.2
      million higher than that reported at December 31, 2009.  The
      year to date increase in the portfolio can be attributed to purchases the
      Bank made to maximize the yield on earning assets in the absence of
      significant new loan originations.    For additional
      information on the Bank’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
      $99.3 million at March 31, 2010, representing an increase of approximately
      $77.9 million over that reported at December 31,
      2009.  Increased balances within this category are attributable
      in large part to the approximately $56.0 million in proceeds the Company
      received related to its March 2010 private
      placement.  Additionally, continued growth in core deposit
      balances contributed to the year to date increase within this
      category.  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 March 31,
2010:





·
            At
      March 31, 2010, the balance of non-performing loans was approximately
      $49.0 million or $10.7 million higher than that reported at December 31,
      2009.  As of March 31, 2010 the balance of non-performing loans
      as a percentage of total gross loans was 6.78% compared to 5.26% as of
      December 31, 2009.  The Bank placed approximately $16.9 million
      in loan balances on non-accruing status.  The Bank also received
      approximately $2.4 million in pay-downs on non-accruing loans, returned
      approximately $2.1 million to accruing status, and charged-off
      approximately $1.5 million in non-accruing balances.  Please see
      “Non-Performing Assets” of this Discussion and Analysis for a more
      complete discussion of the loans the Bank has placed on
      non-accrual.


Heritage
Oaks Bancorp | - 32 -








Management’s
Discussion and Analysis





·
            At
      March 31, 2010, the allowance for loan losses totaled approximately $18.6
      million, representing 2.57% 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 months
      ended March 31, 2010 totaled approximately $5.2 million, an increase of
      approximately $3.1 million from that reported for the same period ended a
      year earlier.  See also “Provision for Loan Losses” of this
      Discussion and Analysis for a more complete discussion regarding loan loss
      provisions.





·
            Charge-offs
      during the first three months of 2010 were approximately $1.5
      million.  Net charge-offs for the first quarter of 2010 totaled
      approximately $1.0 million.  Net charge-offs to average gross
      loans were 0.14% and 0.30% for the three month period ended March 31, 2010
      and 2009, respectively.





·
            OREO
      balances totaled approximately $0.7 million at March 31, 2010, a decline
      of approximately $0.2 million from that reported at December 31,
      2009.  The Bank wrote down the value of OREO by $0.2 million
      during the first quarter of 2010, resulting from the Bank’s acceptance of
      an offer to purchase one property and an updated appraisal of
      another.  The Bank currently anticipates the sale of the
      property for which an offer was accepted to close sometime in the second
      quarter of 2010.





Recent
Developments





Regulatory
Order and Written Agreement





On March
4, 2010, the FDIC and the DFI issued a joint 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 will continue to take all actions necessary to comply with the
Order within the required time frames. Such actions include the completion of
the capital raise discussed below which, following a contribution of a portion
of the proceeds to the Bank, the Bank was brought 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. With the capital raise secured, the Company and Bank
believe they can successfully address the requirements of both the Order and the
Written Agreement.





As of
March 31, 2010, the following provides a summary of the progress the Bank has
made in complying with certain provisions of the Order.





·
            In
      March 2010 the Company raised approximately $56.0 million in capital
      through a private placement with an additional $4.0 million placed in
      escrow for a second closing, pending regulatory approvals required for the
      particular investor making such investment.  Following the
      closing The Company down-streamed the majority of these funds, $48.0
      million, to the Bank as Tier I capital, bringing the Bank in compliance
      with the requirement to increase its Tier I leverage ratio to a level that
      meets or exceeds 10.0% and its Total Risk-Based capital ratio of
      11.5%.





·
            An
      independent study of the management and personnel structure of the Bank
      has begun, with results expected early in the second quarter of
      2010.





·
            During
      2009 the Bank eliminated from its books all assets or portions of assets
      classified as “Loss” and one-half of assets classified as
      “Doubtful.”





·
            The
      Bank is in the process of complying with the August 31, 2010 deadline to
      meet the provision to reduce the level of assets classified as
      “Substandard” in the Report of Examination (“ROE”) to a level not more
      than the greater of $50.0 million or 50% of Tier I capital and the
      allowance for loan losses. Following the Company’s downstream to the Bank
      of a majority of the funds it raised in its March 2010 private placement,
      the Bank has substantially met this
requirement.





·
            The
      Order 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.  Additionally, the Bank’s ALLL had a net year to date
      increase of approximately $4.2 million.  The Bank is also in the
      process of revising its policy for determining the adequacy of the
      allowance for loan losses.


Heritage
Oaks Bancorp | - 33 -








Management’s
Discussion and Analysis





·
            The
      Bank is currently in the process of developing a written plan to
      systematically reduce the amount of loans or other extensions of credit
      advanced, directly or indirectly, to or for the benefit of borrowers in
      the “Commercial Real Estate” concentration, with emphasis on those
      borrowers involved in construction and land
  development.





·
            The
      Bank is in the process of developing a written plan to systematically
      reduce its level of non-performing
assets.





·
            The
      Bank has revised its written lending and collection policy to provide
      further guidance and control over its lending
  function.





·
            The
      Bank has revised its contingency funding plan and its liquidity and funds
      management policy.





·
            The
      Bank has adopted a comprehensive budget for all categories of income and
      expense for the calendar year 2010.





The above
summary does not purport to be an exhaustive list of the items the Bank has made
progress in with respect to the provisions of the Order, it does however provide
a summary of progress the Bank has made with respect to items outlined in the
Order that Management considers to be of significant importance.





As of
March 31, 2010, the following provides a summary of the progress the Bank has
made in complying with the provisions of the Written Agreement:





·
            The
      Company is currently in the process of updating its capital
      plan.





·
            The
      Company has updated its cash flow projections for the calendar year 2010
      with particular emphasis on the uses of cash for debt service, operational
      expenses and other purposes.





For
additional information concerning the Order and the Written Agreement, please
see Note 11. Regulatory Order and Written Agreement, of the consolidated
financial statements filed on this Form 10-Q.  For the full text of
the Order and Written Agreement, please also refer to the Company's current
reports on Form 8-K regarding the Consent Order and Written Agreement which were
filed with the Securities and Exchange Commission on March 10, 2010 and March 8,
2010, respectively.





Private
Placement





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, 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, pending receipt of
regulatory approvals required for the particular investor purchasing such
shares.  For additional information regarding the Company’s March 2010
private placement, please see Note 10. Preferred Stock, of the consolidated
financial statements filed on this Form 10-Q.





Dividends
and Stock Repurchases





During
the first three months of 2010, the Company paid approximately $262 thousand in
dividends on its Series A Senior Preferred Stock issued to the U.S. Treasury
under the CPP.  See also Note 10. Preferred Stock, to the consolidated
financial statements filed on this form 10-Q for additional information about
dividends on the Company’s Series A Senior Preferred Stock.





The
Company paid no dividends on or made repurchases of its common stock during the
first three months of 2010 or for all of 2009.


Heritage
Oaks Bancorp | - 34 -








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)
                    
                    03/31/10
                    
                    
                    12/31/09
                    
                    
                    09/30/09
                    
                    
                    06/30/09
                    
                    
                    03/31/09
                    
                    
                    12/31/08
                    
                    
                    09/30/08
                    
                    
                    06/30/08Return
      on average assets
                    
                    
                    -0.56
                    %
                    
                    
                    -1.43
                    %
                    
                    
                    -2.30
                    %
                    
                    
                    0.23
                    %
                    
                    
                    0.54
                    %
                    
                    
                    -0.63
                    %
                    
                    
                    0.27
                    %
                    
                    
                    0.35
                    %Return
      on average equity
                    
                    
                    -5.70
                    %
                    
                    
                    -15.27
                    %
                    
                    
                    -22.54
                    %
                    
                    
                    2.20
                    %
                    
                    
                    6.04
                    %
                    
                    
                    -6.93
                    %
                    
                    
                    2.94
                    %
                    
                    
                    3.84
                    %Return
      on average common equity
                    
                    
                    -10.93
                    %
                    
                    
                    -22.05
                    %
                    
                    
                    -31.14
                    %
                    
                    
                    1.44
                    %
                    
                    
                    6.21
                    %
                    
                    
                    -6.93
                    %
                    
                    
                    2.94
                    %
                    
                    
                    3.84
                    %Average
      equity to average assets
                    
                    
                    9.88
                    %
                    
                    
                    9.35
                    %
                    
                    
                    10.18
                    %
                    
                    
                    10.68
                    %
                    
                    
                    8.95
                    %
                    
                    
                    9.06
                    %
                    
                    
                    9.16
                    %
                    
                    
                    9.14
                    %Average
      common equity to average assets
                    
                    
                    6.49
                    %
                    
                    
                    7.14
                    %
                    
                    
                    7.87
                    %
                    
                    
                    8.26
                    %
                    
                    
                    8.61
                    %
                    
                    
                    9.06
                    %
                    
                    
                    9.16
                    %
                    
                    
                    9.14
                    %Net
      interest margin
                    
                    
                    4.43
                    %
                    
                    
                    4.81
                    %
                    
                    
                    4.34
                    %
                    
                    
                    4.91
                    %
                    
                    
                    5.03
                    %
                    
                    
                    5.04
                    %
                    
                    
                    5.18
                    %
                    
                    
                    5.28
                    %Efficiency
      ratio*
                    
                    
                    76.88
                    %
                    
                    
                    70.84
                    %
                    
                    
                    95.12
                    %
                    
                    
                    70.02
                    %
                    
                    
                    66.71
                    %
                    
                    
                    66.43
                    %
                    
                    
                    64.40
                    %
                    
                    
                    66.31
                    %Average
      loans to average deposits
                    
                    
                    93.67
                    %
                    
                    
                    93.45
                    %
                    
                    
                    98.20
                    %
                    
                    
                    103.58
                    %
                    
                    
                    112.39
                    %
                    
                    
                    109.95
                    %
                    
                    
                    111.54
                    %
                    
                    
                    109.26
                    %Net
      (loss) / income
                    
                    $
                    (1,339
                    )
                    
                    $
                    (3,416
                    )
                    
                    $
                    (5,242
                    )
                    
                    $
                    507
                    
                    
                    $
                    1,102
                    
                    
                    $
                    (1,254
                    )
                    
                    $
                    534
                    
                    
                    $
                    691Net
      (loss) / income available to common shareholders
                    
                    $
                    (1,690
                    )
                    
                    $
                    (3,767
                    )
                    
                    $
                    (5,594
                    )
                    
                    $
                    257
                    
                    
                    $
                    1,091
                    
                    
                    $
                    (1,254
                    )
                    
                    $
                    534
                    
                    
                    $
                    691(Loss)
      / Earnings Per Common Share:Basic
                    
                    $
                    (0.22
                    )
                    
                    $
                    (0.48
                    )
                    
                    $
                    (0.73
                    )
                    
                    $
                    0.03
                    
                    
                    $
                    0.14
                    
                    
                    $
                    (0.16
                    )
                    
                    $
                    0.07
                    
                    
                    $
                    0.09Diluted
                    
                    $
                    (0.22
                    )
                    
                    $
                    (0.48
                    )
                    
                    $
                    (0.73
                    )
                    
                    $
                    0.03
                    
                    
                    $
                    0.14
                    
                    
                    $
                    (0.16
                    )
                    
                    $
                    0.07
                    
                    
                    $
                    0.09Outstanding
      Shares:Basic
                    
                    
                    7,717,194
                    
                    
                    
                    7,704,060
                    
                    
                    
                    7,699,377
                    
                    
                    
                    7,696,027
                    
                    
                    
                    7,689,317
                    
                    
                    
                    7,660,342
                    
                    
                    
                    7,709,600
                    
                    
                    
                    7,705,174Diluted
                    
                    
                    7,717,194
                    
                    
                    
                    7,704,060
                    
                    
                    
                    7,699,377
                    
                    
                    
                    7,866,962
                    
                    
                    
                    7,824,377
                    
                    
                    
                    7,660,342
                    
                    
                    
                    7,798,321
                    
                    
                    
                    7,830,390





* 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, and SBA
loans.





Local
Economy





The
economy in the Company’s service area is based primarily on agriculture,
tourism, light industry, oil and retail trade. Services supporting these
industries have also developed in the areas of medical, financial and
educational services.  The population of San Luis Obispo County, the
City of Santa Maria (in Northern Santa Barbara County), and the City of Santa
Barbara totaled approximately 267,000, 86,000, and 86,000 respectively,
according to the most recent economic data provided by the U.S. Census
Bureau.  The moderate climate allows a year round growing season 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 and production of
premium quality wines. Vineyards in production have grown significantly over the
past several years throughout the Company’s service area.  Access to
numerous recreational activities 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 our market area, especially in the wine
industry and coastal communities, has provided some support for our local
economy in previous economic downturns and has to some degree provided some
support for the local economy in the current economic environment.


Heritage
Oaks Bancorp | - 35 -








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 our primary market
area.  As the U.S. housing market continued to wane throughout 2009
and economic growth remained weak, the ability of borrowers to satisfy their
obligations to the financial sector has languished.  These among other
factors placed severe stress on the U.S. financial system, leading to a downturn
in economic growth and unprecedented volatility in the U.S. equity and credit
markets.  As mentioned, the Bank’s primary market area has
historically witnessed a more stable level of economic activity; however the
Bank believes these more macro level concerns have started to become more
evident within our market area.  Recent indications show the
unemployment rate within California to be approximately 12.6%.  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 10.2% and 9.9%, respectively.  Additionally, according
to the most recent data available to the Company in regard to hotel occupancy
rates, published by Smith Travel Research, hotel occupancy rates showed a
decline of 2.6%, 4.9% and 12.3% for Paso Robles/San Luis Obispo, Santa
Barbara/Santa Maria and the State of California, respectively when comparing May
2009 to May 2008.





Housing
prices have fallen significantly in California and within the Bank’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.  However, the Company’s market area has seen
increases in home sales over the last year, with San Luis Obispo and Santa
Barbara counties showing sales increases of approximately 8% and 12%,
respectively for 2009 when compared to that reported for
2008.  Increased sales can be attributed in part to sales of
distressed assets and the work through of any additional supply added to the
market in recent years during the economic downturn.   Although
the level of sales in the Company’s market area has increased on a year over
year basis, recent information provided by DataQuick indicates home prices
declined in 2009 compared to that reported for December 2008.  Prices
in some of the largest cities in our market area such as: San Luis Obispo, Paso
Robles, Santa Barbara, and Santa Maria have shown year over year declines of
approximately 16%, 13%, 16% and 7%, respectively as of December
2009.  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 December 2009 may
be impacted by compositional changes in housing demand.





Although
prices in the Company’s market area remain well below the highs witnessed in
2006 and 2007, a significant 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.





Management
acknowledges that as economic conditions continue to wane on state and national
levels and as the level of unemployment continues to rise, conditions within our
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 will no doubt impact the borrowers to whom the Bank has
extended credit, which may further impact our 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
accounts and net of any deferred fees or costs on originated loans, or
unamortized premiums or discounts on purchased loans.





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


Heritage
Oaks Bancorp | - 36 -








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 Bank 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 Bank recognizes interest income on impaired loans
based on its existing methods of recognizing interest income on non-accrual
loans.  All loans are generally charged-off at such time 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 date of the balance sheet.  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
a provision for loan losses, which is charged to earnings and reduced by
charge-offs, net of recoveries.  Changes in the allowance relating to
impaired loans are charged or credited to the provision for loan
losses.  Because of uncertainties inherent in the estimation process,
Management’s estimate of credit losses inherent in the loan portfolio and the
related allowance may change.





As
mentioned, loans are considered impaired if, based on current information and
events, it is probable that the Bank will be unable to collect all amounts due
according to the contractual terms of the loan agreement.  In certain
instances the Bank 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 Bank 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.  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 | - 37 -








Management’s
Discussion and Analysis





Appraisals
for Collateral Dependent Loans





Once a
loan has been funded, the Bank 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 Bank to
validate all covenants and the risk grade assigned to the loan.  If
during the review process the Bank 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 Bank no longer expects to collect all previously determined
amounts related to the loan as stipulated in the loan’s original agreement, the
Bank 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 Bank’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 Bank’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 Bank to hold such securities for a period of time sufficient to
allow for any anticipated recovery in fair value and (6) in the case of mortgage
related securities, current cash flows, credit enhancements, loan-to-values,
credit scores, delinquency and default rates.





Goodwill
and Other Intangible Assets





As
discussed in the 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.  We use an estimate of future earnings to support our
position that the benefit of our 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 our net income will be reduced.  In the fourth quarter
of 2009, the Company performed an in depth analysis of its deferred tax asset to
determine if the current carrying value of the deferred tax asset would be
realized in future periods.  Based on the Company’s analysis and all
currently available information, the Company believes that as of March 31, 2010
the carrying value of the deferred tax asset can be supported and that a
valuation allowance is not necessary at this time.


Heritage
Oaks Bancorp | - 38 -








Management’s
Discussion and Analysis





Results
of Operations





The
Company’s operating results for the three months ended March 31, 2010 when
compared to the same periods ended a year earlier were impacted considerably by
higher provisions for loan losses.  Provisions for loan losses during
the three months ended March 31, 2010 totaled approximately $5.2 million, an
increase of approximately $3.1 million from that reported in the same period
ended a year earlier.  Increases in non-accruing loan balances,
increases in the balance of loans the Bank classifies as substandard and
continued weakness in economic conditions were drivers behind the increased loan
loss provisions during the first quarter of 2010.  Please see
“Provision for Loan Losses” of this Discussion and Analysis for additional
information related to provision for loan losses.  Also impacting
operating results during the first quarter of 2010 were interest reversals of
approximately $0.2 million related to loans the Bank placed on
non-accrual.  Additionally, total foregone interest related to
impaired loans totaled approximately $0.6 million in the first
quarter.  Interest reversals and foregone interest on impaired loans
were factors that negatively impacted the net interest margin during the first
quarter of 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 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 Bank’s loan portfolio are
currently at their floors.  Given that current interest rates are
considerably lower than most floors in the loan portfolio, the Bank 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 Bank was able to significantly increase the level of floating rate
liabilities in the form of money market and short term certificate accounts,
bringing the balance sheet to a more neutral position regarding interest rate
sensitivity.  This was instrumental in mitigating substantial year
over year declines in the net interest margin as a result of dramatic declines
in the overnight Federal Funds and Prime rates during 2008.





For the
three months ended March 31, 2010 and 2009, the net interest margin was 4.43%
and 5.03%, respectively.  This represents a decline of 60 basis points
for the first quarter of 2010 when compared to the same period ended a year
earlier.  The net interest margin was negatively impacted by
approximately 11 basis points from interest reversals related to additional
loans the Bank placed on non-accrual in the first quarter of
2010.  Total foregone interest negatively impacted the net interest
margin by approximately 26 basis points during the first quarter of
2010.  Additionally, significantly 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 0.23% for the first quarter of 2010.





Historically,
the largest and most variable source of income for the Company is net interest
income. The results of operations for the three months ended March 31, 2010 and
2009 reflect the impact of historically low interest rates throughout the last
two years and a significantly weakened economy.





Net
Interest Income and Margin





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


Heritage
Oaks Bancorp | - 39 -








Management’s
Discussion and Analysis





The table
below sets forth average balance sheet information, interest income and expense,
average yields and rates and net interest income and margin for the three months
ended March 31, 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 endingMarch
      31, 2010
                                                    
                                                    
                                                    March
      31, 2009Yield/
                                                    
                                                    
                                                    Income/
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    Yield/
                                                    
                                                    
                                                    Income/(dollars
      in thousands)
                                                    
                                                    Balance
                                                    
                                                    
                                                    Rate
      (4)
                                                    
                                                    
                                                    Expense
                                                    
                                                    
                                                    Balance
                                                    
                                                    
                                                    Rate
      (4)
                                                    
                                                    
                                                    ExpenseInterest
      Earning Assets:Investments
      with other banks
                                                    
                                                    $
                                                    119
                                                    
                                                    
                                                    
                                                    1.58
                                                    %
                                                    
                                                    $
                                                    -
                                                    
                                                    
                                                    $
                                                    119
                                                    
                                                    
                                                    
                                                    3.41
                                                    %
                                                    
                                                    $
                                                    1Interest
      bearing due from Federal Reserve
                                                    
                                                    
                                                    48,884
                                                    
                                                    
                                                    
                                                    0.23
                                                    %
                                                    
                                                    
                                                    28
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    0.00
                                                    %
                                                    
                                                    
                                                    -Federal
      funds sold
                                                    
                                                    
                                                    2,475
                                                    
                                                    
                                                    
                                                    0.16
                                                    %
                                                    
                                                    
                                                    1
                                                    
                                                    
                                                    
                                                    12,844
                                                    
                                                    
                                                    
                                                    0.22
                                                    %
                                                    
                                                    
                                                    7Investment
      securities taxable
                                                    
                                                    
                                                    103,515
                                                    
                                                    
                                                    
                                                    4.01
                                                    %
                                                    
                                                    
                                                    1,023
                                                    
                                                    
                                                    
                                                    45,201
                                                    
                                                    
                                                    
                                                    4.98
                                                    %
                                                    
                                                    
                                                    555Investment
      securities non taxable
                                                    
                                                    
                                                    22,960
                                                    
                                                    
                                                    
                                                    4.54
                                                    %
                                                    
                                                    
                                                    257
                                                    
                                                    
                                                    
                                                    17,163
                                                    
                                                    
                                                    
                                                    4.40
                                                    %
                                                    
                                                    
                                                    186Loans
      (1) (2)
                                                    
                                                    
                                                    732,248
                                                    
                                                    
                                                    
                                                    6.17
                                                    %
                                                    
                                                    
                                                    11,141
                                                    
                                                    
                                                    
                                                    695,774
                                                    
                                                    
                                                    
                                                    6.50
                                                    %
                                                    
                                                    
                                                    11,147Total
      interest earning assets
                                                    
                                                    
                                                    910,201
                                                    
                                                    
                                                    
                                                    5.55
                                                    %
                                                    
                                                    
                                                    12,450
                                                    
                                                    
                                                    
                                                    771,101
                                                    
                                                    
                                                    
                                                    6.26
                                                    %
                                                    
                                                    
                                                    11,896Allowance
      for possible loan losses
                                                    
                                                    
                                                    (17,354
                                                    )
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    (10,623
                                                    )Other
      assets
                                                    
                                                    
                                                    72,283
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    66,896Total
      assets
                                                    
                                                    $
                                                    965,130
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    $
                                                    827,374Interest
      Bearing Liabilities:Interest
      bearing demand
                                                    
                                                    $
                                                    80,211
                                                    
                                                    
                                                    
                                                    1.08
                                                    %
                                                    
                                                    
                                                    214
                                                    
                                                    
                                                    $
                                                    64,627
                                                    
                                                    
                                                    
                                                    0.53
                                                    %
                                                    
                                                    $
                                                    84Savings
                                                    
                                                    
                                                    28,048
                                                    
                                                    
                                                    
                                                    0.26
                                                    %
                                                    
                                                    
                                                    18
                                                    
                                                    
                                                    
                                                    22,069
                                                    
                                                    
                                                    
                                                    0.17
                                                    %
                                                    
                                                    
                                                    9Money
      market
                                                    
                                                    
                                                    268,885
                                                    
                                                    
                                                    
                                                    1.28
                                                    %
                                                    
                                                    
                                                    848
                                                    
                                                    
                                                    
                                                    173,145
                                                    
                                                    
                                                    
                                                    1.55
                                                    %
                                                    
                                                    
                                                    660Time
      deposits
                                                    
                                                    
                                                    227,374
                                                    
                                                    
                                                    
                                                    2.05
                                                    %
                                                    
                                                    
                                                    1,147
                                                    
                                                    
                                                    
                                                    142,543
                                                    
                                                    
                                                    
                                                    2.71
                                                    %
                                                    
                                                    
                                                    954Brokered
      money market funds
                                                    
                                                    
                                                    1,000
                                                    
                                                    
                                                    
                                                    0.81
                                                    %
                                                    
                                                    
                                                    2
                                                    
                                                    
                                                    
                                                    40,860
                                                    
                                                    
                                                    
                                                    0.64
                                                    %
                                                    
                                                    
                                                    64Brokered
      time deposits
                                                    
                                                    
                                                    7,077
                                                    
                                                    
                                                    
                                                    2.41
                                                    %
                                                    
                                                    
                                                    42
                                                    
                                                    
                                                    
                                                    29,992
                                                    
                                                    
                                                    
                                                    2.08
                                                    %
                                                    
                                                    
                                                    154Total
      interest bearing deposits
                                                    
                                                    
                                                    612,595
                                                    
                                                    
                                                    
                                                    1.50
                                                    %
                                                    
                                                    
                                                    2,271
                                                    
                                                    
                                                    
                                                    473,236
                                                    
                                                    
                                                    
                                                    1.65
                                                    %
                                                    
                                                    
                                                    1,925Federal
      funds purchased
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    0.00
                                                    %
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    650
                                                    
                                                    
                                                    
                                                    1.25
                                                    %
                                                    
                                                    
                                                    2Securities
      sold under repurchase agreements
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    0.00
                                                    %
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    2,638
                                                    
                                                    
                                                    
                                                    0.15
                                                    %
                                                    
                                                    
                                                    1Other
      secured borrowing
                                                    
                                                    
                                                    966
                                                    
                                                    
                                                    
                                                    4.62
                                                    %
                                                    
                                                    
                                                    11
                                                    
                                                    
                                                    
                                                    -
                                                    
                                                    
                                                    
                                                    0.00
                                                    %
                                                    
                                                    
                                                    -Federal
      Home Loan Bank borrowing
                                                    
                                                    
                                                    65,000
                                                    
                                                    
                                                    
                                                    0.57
                                                    %
                                                    
                                                    
                                                    92
                                                    
                                                    
                                                    
                                                    109,478
                                                    
                                                    
                                                    
                                                    0.91
                                                    %
                                                    
                                                    
                                                    246Junior
      subordinated debentures
                                                    
                                                    
                                                    13,403
                                                    
                                                    
                                                    
                                                    3.90
                                                    %
                                                    
                                                    
                                                    129
                                                    
                                                    
                                                    
                                                    13,403
                                                    
                                                    
                                                    
                                                    4.69
                                                    %
                                                    
                                                    
                                                    155Total
      borrowed funds
                                                    
                                                    
                                                    79,369
                                                    
                                                    
                                                    
                                                    1.19
                                                    %
                                                    
                                                    
                                                    232
                                                    
                                                    
                                                    
                                                    126,169
                                                    
                                                    
                                                    
                                                    1.30
                                                    %
                                                    
                                                    
                                                    404Total
      interest bearing liabilities
                                                    
                                                    
                                                    691,964
                                                    
                                                    
                                                    
                                                    1.47
                                                    %
                                                    
                                                    
                                                    2,503
                                                    
                                                    
                                                    
                                                    599,405
                                                    
                                                    
                                                    
                                                    1.58
                                                    %
                                                    
                                                    
                                                    2,329Non
      interest bearing demand
                                                    
                                                    
                                                    169,149
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    145,849Total
      funding
                                                    
                                                    
                                                    861,113
                                                    
                                                    
                                                    
                                                    1.18
                                                    %
                                                    
                                                    
                                                    2,503
                                                    
                                                    
                                                    
                                                    745,254
                                                    
                                                    
                                                    
                                                    1.27
                                                    %
                                                    
                                                    
                                                    2,329Other
      liabilities
                                                    
                                                    
                                                    8,667
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    8,086Total
      liabilities
                                                    
                                                    $
                                                    869,780
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    $
                                                    753,340Stockholders'
      Equity:Preferred
      stock
                                                    
                                                    $
                                                    31,137
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    $
                                                    2,554Common
      stock
                                                    
                                                    
                                                    48,755
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    48,649Additional
      paid in capital
                                                    
                                                    
                                                    3,282
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    1,338Retained
      earnings
                                                    
                                                    
                                                    12,636
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    22,777Valuation
      allowance investments
                                                    
                                                    
                                                    (460
                                                    )
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    (1,284
                                                    )Total
      stockholders' equity
                                                    
                                                    
                                                    95,350
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    74,034Total
      liabilities and stockholders' equity
                                                    
                                                    $
                                                    965,130
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    $
                                                    827,374Net
      interest income
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    $
                                                    9,947
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    $
                                                    9,567Net
      interest margin (3)
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    4.43
                                                    %
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    
                                                    5.03
                                                    %


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


(2)
            Loan
      fees of $200 and $258 for the three months ending March 31, 2010 and 2009,
      respectivelyhave
      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 | - 40 -







Management’s
Discussion and Analysis


The table
below sets forth changes in average interest earning assets and their respective
yields for the three month periods ending March 31, 2010 and 2009:





Average Balance
                          
                          
                          
                          
                          
                          
                          
                          
                          Average Yieldfor the three months ending
                          
                          
                          
                          
                          
                          
                          
                          
                          for the three months endingMarch 31,
                          
                          
                          Variance
                          
                          
                          March 31,(dollars in thousands)
                          
                          2010
                          
                          
                          2009
                          
                          
                          dollar
                          
                          
                          percentage
                          
                          
                          2010
                          
                          
                          2009
                          
                          
                          VarianceInvestments
      with other banks
                          
                          $
                          119
                          
                          
                          $
                          119
                          
                          
                          $
                          -
                          
                          
                          
                          0.00
                          %
                          
                          
                          1.58
                          %
                          
                          
                          3.41
                          %
                          
                          
                          -1.83
                          %Interest
      bearing due from Federal Reserve
                          
                          
                          48,884
                          
                          
                          
                          -
                          
                          
                          
                          48,884
                          
                          
                          
                          100.00
                          %
                          
                          
                          0.23
                          %
                          
                          
                          0.00
                          %
                          
                          
                          0.23
                          %Federal
      funds sold
                          
                          
                          2,475
                          
                          
                          
                          12,844
                          
                          
                          
                          (10,369
                          )
                          
                          
                          -80.73
                          %
                          
                          
                          0.16
                          %
                          
                          
                          0.22
                          %
                          
                          
                          -0.06
                          %Investment
      securities taxable
                          
                          
                          103,515
                          
                          
                          
                          45,201
                          
                          
                          
                          58,314
                          
                          
                          
                          129.01
                          %
                          
                          
                          4.01
                          %
                          
                          
                          4.98
                          %
                          
                          
                          -0.97
                          %Investment
      securities non taxable
                          
                          
                          22,960
                          
                          
                          
                          17,163
                          
                          
                          
                          5,797
                          
                          
                          
                          33.78
                          %
                          
                          
                          4.54
                          %
                          
                          
                          4.40
                          %
                          
                          
                          0.14
                          %Loans
      (1) (2)
                          
                          
                          732,248
                          
                          
                          
                          695,774
                          
                          
                          
                          36,474
                          
                          
                          
                          5.24
                          %
                          
                          
                          6.17
                          %
                          
                          
                          6.50
                          %
                          
                          
                          -0.33
                          %Total
      interest earning assets
                          
                          $
                          910,201
                          
                          
                          $
                          771,101
                          
                          
                          $
                          139,100
                          
                          
                          
                          18.04
                          %
                          
                          
                          5.55
                          %
                          
                          
                          6.26
                          %
                          
                          
                          -0.71
                          %


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


(2) Loan
fees of $200 and $258 for the three months ending March 31, 2010 and 2009,
respectively have been included in the interest income computation.





At March
31, 2010, average interest earning assets were approximately $139.1 million
higher than that reported over the same three month period ended a year
earlier.  Organic loan growth, higher interest bearing due from
balances and investment securities are the primary factors behind the
increase.  The significant increase in interest bearing due from
balances as well as investment securities is primarily the result of a $130.6
million year over year increase in deposit balances.  The yield on
earning assets for the three months ended March 31, 2010 was 5.55% compared to
6.26% for the same period 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 foregone interest on non-accruing
loans as well as a significant increase in the level of lower yielding short
term investment balances.





For the
three months ended March 31, 2010 the yield on the loan portfolio was 6.17% or
33 basis points lower than that reported for the same period ended a year
earlier.  Impacting the yield on the loan portfolio were approximately
$0.2 million in interest reversals related to additional loans the Bank placed
on non-accrual during the first quarter of 2010.  These reversals
negatively impacted the yield on the portfolio by approximately 13 basis points
and the yield on earnings assets by 10 basis points.  For the three
months ended March 31, 2010 total foregone interest related to non-accruing loan
balances totaled approximately $0.6 million and negatively impacted the yield on
the portfolio by approximately 32 basis points and the yield on earning assets
by approximately 26 basis points.





Throughout
the last twelve months the Bank 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
Bank’s liquidity position was enhanced markedly over the last twelve months as a
result of this initiative, it 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 Bank
might otherwise earn if those funds were invested in loans.  Although
average loan balances increased approximately $36.5 million year over year, the
level of deposit growth has significantly outpaced the level of new loan
originations.  New loan originations have slowed due in part to a
decline in loan demand and fewer loans that meet the Bank’s underwriting
criteria.  As a result, in an effort to maximize the yield on interest
earning assets in the absence of significant new loan originations, the Bank 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 Bank to maximize yields on
excess liquidity while ensuring adequate cash flow to support potential loan
growth in future periods.


Heritage
Oaks Bancorp | - 41 -








Management’s
Discussion and Analysis





The
tables below set forth changes in average interest bearing liabilities and their
respective rates for the three months ended March 31, 2010 compared to the same
period ended in 2009:





Average Balance
                          
                          
                          
                          
                          
                          
                          
                          
                          Average Ratefor the three months ending
                          
                          
                          
                          
                          
                          
                          
                          
                          for the three months endingMarch 31,
                          
                          
                          Variance
                          
                          
                          March 31,(dollars in thousands)
                          
                          2010
                          
                          
                          2009
                          
                          
                          dollar
                          
                          
                          percentage
                          
                          
                          2010
                          
                          
                          2009
                          
                          
                          VarianceInterest
      bearing demand
                          
                          $
                          80,211
                          
                          
                          $
                          64,627
                          
                          
                          $
                          15,584
                          
                          
                          
                          24.11
                          %
                          
                          
                          1.08
                          %
                          
                          
                          0.53
                          %
                          
                          
                          0.55
                          %Savings
                          
                          
                          28,048
                          
                          
                          
                          22,069
                          
                          
                          
                          5,979
                          
                          
                          
                          27.09
                          %
                          
                          
                          0.26
                          %
                          
                          
                          0.17
                          %
                          
                          
                          0.09
                          %Money
      market
                          
                          
                          268,885
                          
                          
                          
                          173,145
                          
                          
                          
                          95,740
                          
                          
                          
                          55.29
                          %
                          
                          
                          1.28
                          %
                          
                          
                          1.55
                          %
                          
                          
                          -0.27
                          %Time
      deposits
                          
                          
                          227,374
                          
                          
                          
                          142,543
                          
                          
                          
                          84,831
                          
                          
                          
                          59.51
                          %
                          
                          
                          2.05
                          %
                          
                          
                          2.71
                          %
                          
                          
                          -0.66
                          %Brokered
      money market funds
                          
                          
                          1,000
                          
                          
                          
                          40,860
                          
                          
                          
                          (39,860
                          )
                          
                          
                          -97.55
                          %
                          
                          
                          0.81
                          %
                          
                          
                          0.64
                          %
                          
                          
                          0.17
                          %Brokered
      time deposits
                          
                          
                          7,077
                          
                          
                          
                          29,992
                          
                          
                          
                          (22,915
                          )
                          
                          
                          -76.40
                          %
                          
                          
                          2.41
                          %
                          
                          
                          2.08
                          %
                          
                          
                          0.33
                          %Federal
      funds purchased
                          
                          
                          -
                          
                          
                          
                          650
                          
                          
                          
                          (650
                          )
                          
                          
                          -100.00
                          %
                          
                          
                          0.00
                          %
                          
                          
                          1.25
                          %
                          
                          
                          -1.25
                          %Securities
      sold under repurchase agreements
                          
                          
                          -
                          
                          
                          
                          2,638
                          
                          
                          
                          (2,638
                          )
                          
                          
                          -100.00
                          %
                          
                          
                          0.00
                          %
                          
                          
                          0.15
                          %
                          
                          
                          -0.15
                          %Other
      secured borrowing
                          
                          
                          966
                          
                          
                          
                          -
                          
                          
                          
                          966
                          
                          
                          
                          100.00
                          %
                          
                          
                          4.62
                          %
                          
                          
                          0.00
                          %
                          
                          
                          4.62
                          %Federal
      Home Loan Bank borrowing
                          
                          
                          65,000
                          
                          
                          
                          109,478
                          
                          
                          
                          (44,478
                          )
                          
                          
                          -40.63
                          %
                          
                          
                          0.57
                          %
                          
                          
                          0.91
                          %
                          
                          
                          -0.34
                          %Junior
      subordinated debentures
                          
                          
                          13,403
                          
                          
                          
                          13,403
                          
                          
                          
                          -
                          
                          
                          
                          0.00
                          %
                          
                          
                          3.90
                          %
                          
                          
                          4.69
                          %
                          
                          
                          -0.79
                          %Total
      interest bearing liabilities
                          
                          $
                          691,964
                          
                          
                          $
                          599,405
                          
                          
                          $
                          92,559
                          
                          
                          
                          15.44
                          %
                          
                          
                          1.47
                          %
                          
                          
                          1.58
                          %
                          
                          
                          -0.11
                          %





At March
31, 2010, the balance of interest bearing liabilities was approximately $92.6
million higher than that reported over the same three month period 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 Bank 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 Bank to pay-down approximately
$44.5 million in average borrowings from the FHLB as well as $62.8 million in
brokered deposits, relying less on alternative funding sources.





The
significant increases in floating rate deposit balances over the last year and
the ability to re-price those funds as needed assisted the Bank in keeping the
overall cost of funding down and mitigating the decline in the net interest
margin.  At March 31, 2010 approximately $407.0 million or 58.4% of
the Company’s interest bearing liabilities possess a floating rate.





For the
first quarter of 2010 the average rate paid on interest bearing liabilities was
1.47%, down 11 basis points from that reported for the same period 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.


Heritage
Oaks Bancorp | - 42 -








Management’s
Discussion and Analysis





The
volume and rate variances table below sets forth the dollar difference in
interest earned and paid for each major category of interest-earning assets and
interest-bearing liabilities for the three month period ended March 31, 2010
over the same period 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 endedMarch 31, 2010 over 2009(dollars
      in thousands)
                      
                      Volume
                      
                      
                      Rate
                      
                      
                      TotalInterest
      incomeInvestments
      with other banks
                      
                      $
                      -
                      
                      
                      $
                      (1
                      )
                      
                      $
                      (1
                      )Interest
      bearing due from Federal Reserve
                      
                      
                      28
                      
                      
                      
                      -
                      
                      
                      
                      28Federal
      funds sold
                      
                      
                      (4
                      )
                      
                      
                      (2
                      )
                      
                      
                      (6
                      )Investment
      securities taxable
                      
                      
                      594
                      
                      
                      
                      (126
                      )
                      
                      
                      468Investment
      securities non-taxable (2)
                      
                      
                      98
                      
                      
                      
                      9
                      
                      
                      
                      107Taxable
      equivalent adjustment (2)
                      
                      
                      (33
                      )
                      
                      
                      (3
                      )
                      
                      
                      (36
                      )Loans
      (1)
                      
                      
                      569
                      
                      
                      
                      (575
                      )
                      
                      
                      (6
                      )Net
      increase / (decrease)
                      
                      
                      1,252
                      
                      
                      
                      (698
                      )
                      
                      
                      554Interest
      expenseSavings,
      NOW, money market
                      
                      
                      336
                      
                      
                      
                      (9
                      )
                      
                      
                      327Time
      deposits
                      
                      
                      466
                      
                      
                      
                      (273
                      )
                      
                      
                      193Brokered
      funds
                      
                      
                      (273
                      )
                      
                      
                      99
                      
                      
                      
                      (174
                      )Federal
      funds purchased
                      
                      
                      (1
                      )
                      
                      
                      (1
                      )
                      
                      
                      (2
                      )Other
      borrowings
                      
                      
                      (84
                      )
                      
                      
                      (60
                      )
                      
                      
                      (144
                      )Long
      term debt
                      
                      
                      -
                      
                      
                      
                      (26
                      )
                      
                      
                      (26
                      )Net
      increase / (decrease)
                      
                      
                      444
                      
                      
                      
                      (270
                      )
                      
                      
                      174Total
      net increase / (decrease)
                      
                      $
                      808
                      
                      
                      $
                      (428
                      )
                      
                      $
                      380





(1) Loan
fees of $200 and $258 for the three months ending March 31, 2010 and 2009,
respectively.


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





Non-Interest
Income





The table
below sets forth changes in non-interest income for the three month period ended
March 31, 2010 compared to the same period ended in 2009:





For the three months endedMarch 31,
                        
                        
                        Variance(dollars in thousands)
                        
                        2010
                        
                        
                        2009
                        
                        
                        dollar
                        
                        
                        percentageService
      charges on deposit accounts
                        
                        $
                        625
                        
                        
                        $
                        712
                        
                        
                        $
                        (87
                        )
                        
                        
                        -12.22
                        %ATM/Debit
      and credit card transaction/interchange fees
                        
                        
                        259
                        
                        
                        
                        215
                        
                        
                        
                        44
                        
                        
                        
                        20.47
                        %Bancard
                        
                        
                        36
                        
                        
                        
                        37
                        
                        
                        
                        (1
                        )
                        
                        
                        -2.70
                        %Mortgage
      origination fees
                        
                        
                        340
                        
                        
                        
                        330
                        
                        
                        
                        10
                        
                        
                        
                        3.03
                        %Earnings
      on bank owned life insurance
                        
                        
                        151
                        
                        
                        
                        122
                        
                        
                        
                        29
                        
                        
                        
                        23.77
                        %Other
      commissions and fees
                        
                        
                        175
                        
                        
                        
                        149
                        
                        
                        
                        26
                        
                        
                        
                        17.45
                        %Gain
      on sale of investment securities
                        
                        
                        -
                        
                        
                        
                        122
                        
                        
                        
                        (122
                        )
                        
                        
                        -100.00
                        %Loss
      on sale of OREO
                        
                        
                        -
                        
                        
                        
                        (27
                        )
                        
                        
                        27
                        
                        
                        
                        100.00
                        %Total
      non-interest income
                        
                        $
                        1,586
                        
                        
                        $
                        1,660
                        
                        
                        $
                        (74
                        )
                        
                        
                        -4.46
                        %





Non-interest
income for the first quarter of 2010 totaled approximately $1.6 million, a
decline of approximately $0.1 million from that reported in the year ago
period.  The primary drivers behind the year over year decline can be
attributed to the absence of a $0.1 million gain on the sale of investment
securities and a $0.1 million decline in service charge income.  The
Company attributes the decline in service charge income to better cash
management practices of business clients in the current economic
environment.


Heritage
Oaks Bancorp | - 43 -








Management’s
Discussion and Analysis





Offsetting
these declines were increases in the categories of ATM/Debit card
transaction/interchange income and earnings on bank owned life
insurance.  Higher transaction/interchange income is attributable to
greater focus on debit card usage in conjunction with additional core
relationships the Bank obtained over the last twelve months.  The
increase in earnings on bank owned life insurance can be attributed to
additional policies the Bank purchased in the second half of 2009 for certain
executive officers.





Mortgage
origination fees remained relatively unchanged in the first quarter of 2010 from
that reported a year earlier.  This can be attributed to a decline in
the level of re-financing activity, which was elevated in 2009 due to the
significant drop in interest rates witnessed in the latter half of
2008.





The table
below illustrates the change in the number and total dollar volume of mortgage
loans originated during the three months ended March 31, 2010 when compared to
the same period ended in 2009:





For the three months ended March 31,(dollars in thousands)
                  
                  2010
                  
                  
                  2009
                  
                  
                  VarianceDollar
      volume
                  
                  $
                  29,686
                  
                  
                  $
                  42,065
                  
                  
                  
                  -29.4
                  %Number
      of loans
                  
                  
                  89
                  
                  
                  
                  129
                  
                  
                  
                  -31.0
                  %





Non-Interest
Expenses





The table
below sets forth changes in non-interest expenses for the three month period
ended March 31, 2010 compared to the same period ended in 2009:





For the three months endedMarch 31,
                        
                        
                        Variance(dollars in thousands)
                        
                        2010
                        
                        
                        2009
                        
                        
                        dollar
                        
                        
                        percentageSalaries
      and employee benefits
                        
                        $
                        4,378
                        
                        
                        $
                        3,803
                        
                        
                        $
                        575
                        
                        
                        
                        15.12
                        %Occupancy
                        
                        
                        933
                        
                        
                        
                        852
                        
                        
                        
                        81
                        
                        
                        
                        9.51
                        %Equipment
                        
                        
                        328
                        
                        
                        
                        325
                        
                        
                        
                        3
                        
                        
                        
                        0.92
                        %Promotional
                        
                        
                        179
                        
                        
                        
                        101
                        
                        
                        
                        78
                        
                        
                        
                        77.23
                        %Data
      processing
                        
                        
                        655
                        
                        
                        
                        670
                        
                        
                        
                        (15
                        )
                        
                        
                        -2.24
                        %Stationery
      and supplies
                        
                        
                        122
                        
                        
                        
                        105
                        
                        
                        
                        17
                        
                        
                        
                        16.19
                        %Regulatory
      fees
                        
                        
                        612
                        
                        
                        
                        143
                        
                        
                        
                        469
                        
                        
                        
                        327.97
                        %Audit
      and tax costs
                        
                        
                        143
                        
                        
                        
                        148
                        
                        
                        
                        (5
                        )
                        
                        
                        -3.38
                        %Amortization
      of core deposit intangible
                        
                        
                        129
                        
                        
                        
                        263
                        
                        
                        
                        (134
                        )
                        
                        
                        -50.95
                        %Director
      fees
                        
                        
                        128
                        
                        
                        
                        83
                        
                        
                        
                        45
                        
                        
                        
                        54.22
                        %Communications
                        
                        
                        82
                        
                        
                        
                        62
                        
                        
                        
                        20
                        
                        
                        
                        32.26
                        %Loan
      department
                        
                        
                        424
                        
                        
                        
                        222
                        
                        
                        
                        202
                        
                        
                        
                        90.99
                        %Other
                        
                        
                        753
                        
                        
                        
                        648
                        
                        
                        
                        105
                        
                        
                        
                        16.20
                        %Total
      non-interest expense
                        
                        $
                        8,866
                        
                        
                        $
                        7,425
                        
                        
                        $
                        1,441
                        
                        
                        
                        19.41
                        %





Salary
and Employee Benefits





Salaries
and employee related expenses increased approximately $0.6 million during the
three months ended March 31, 2010 when compared to that reported in the same
period ended a year earlier.  The expansion of the Bank’s management
team in conjunction with additions to the Bank’s special assets department
contributed to the year over year increase within this category.





Occupancy
Expenses





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





Promotion
Expenses





Year over
year increases within this category can be attributable to costs associated with
promotional efforts designed to attract and retain core deposit
balances.


Heritage
Oaks Bancorp | - 44 -








Management’s
Discussion and Analysis





Regulatory
Fees





For the
three months ended March 31, 2010, regulatory fees totaled approximately $0.6
million, an increase of approximately $0.5 million from that reported in the
same period a year earlier.  Increases within this category can be
attributed in large part to higher FDIC insurance costs, primarily due to a
change in the Bank’s risk ratings.  The Bank 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 months ended March 31, 2010 CDI amortization
was approximately $0.1 million lower than that reported for the same period
ended in 2009 of which substantially all can be attributed to the Business First
acquisition.





Loan
Department Costs





For the
three months ended March 31, 2010, loan department costs increased approximately
$0.2 million from that reported in the same three month period ended a year
earlier.  The year over year increase within this category can be
attributed in large part to a $0.1 million increase in write-downs on OREO as
well as an increase in legal fees and other costs associated with managing
substandard and non-performing assets.




Provision
for Income Taxes





For the
three month period ended March 31, 2010 the Company recorded an income tax
benefit of approximately $1.2 million.  This compares to the $0.6
million in income tax expense the Company recorded for the same period ended in
2009.  The year over year decline within this category can be
attributed in large part to substantial increases in provisions for loan losses
during the first quarter of 2010.  Income tax benefits for the three
month period ended March 31, 2010 were 47.1% of the Company’s pre-tax
loss.  The effective tax rate for the same period ended a year earlier
was 34.9%.  The primary reason behind the increase in the Company’s
effective tax rate can be attributed in large part to the approximate net $0.5
million in non-taxable income related to holdings of municipal securities, bank
owned life insurance, and interest income earned on loans with preferential tax
treatment.





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 Bank
recognizes that credit losses will be experienced and the risk of loss will vary
with, among other things, general economic conditions; the type of loan being
made; the creditworthiness of the borrower over the term of the loan and in the
case of a collateralized loan, the quality of the collateral for such
loan.  The allowance for loan losses represents the Bank’s 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 Bank 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 Bank makes monthly evaluations
as to the adequacy of the allowance for loan losses and makes adjustments to the
related provision for loan losses accordingly.


Heritage
Oaks Bancorp | - 45 -








Management’s
Discussion and Analysis





The Bank
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 Bank 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 Bank 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
Bank’s Directors, Loan Committee and full Board of Directors, and as
adjustments, either positive or negative, become necessary, a corresponding
increase or decrease is made in the provision for loan losses.  The
methodology used to determine the adequacy of the allowance for loan losses and
any resulting provision for loan losses for the three months ended March 31,
2010 is consistent with prior periods.





The
Bank’s provision for loan losses was $5.2 million in the first quarter of 2010,
an increase of approximately $3.1 million from that reported in the same period
ended a year earlier.  Continued weakness in economic conditions, an
increase in the level of non-performing loans and elevated levels of substandard
credits have led the Bank to increase the allowance as required by monthly
analyses it conducts in determining its adequacy to cover potential losses in
the loan portfolio.





During
the first quarter of 2010 and in expectation of due diligence to be conducted as
part of the Company’s March 2010 private placement, the Bank contracted with an
independent third party to perform an aggressive credit review of 153 of the
largest commercial and commercial real estate loans held by the
Bank.  The total principal balance reviewed was approximately $377.0
million or approximately 50% of the outstanding loan portfolio as of the review
date. The objective of this review was to determine loans that had cash flow or
repayment weaknesses (as measured by their ability to service debt from a
historical perspective), and, which also had some collateral deficiencies or
unknown collateral values to identify a possible “worst case scenario” for
performance of the Bank’s commercial and commercial real estate portfolio
utilizing certain assumptions about the performance of such loans within certain
risk grading classifications. Based solely on assumptions about the performance
of loans within certain risk grading classifications and extrapolating the
potential loss over the remaining portfolio, the review identified certain
additional levels of potential problem credits.  The Bank is using
this information to assist in identifying credit weaknesses earlier in the cycle
to help mitigate future losses and to assist in its analysis of the allowance
for loan losses.





The Bank
also employs the use of a “watch list” and loan grading system to assist in
monitoring the quality of certain credits in the loan portfolio.  As
loans on the watch list and any other loan within the portfolio experience
deterioration, the Bank typically moves to downgrade such loans, resulting in an
increase in the required allowance to cover any potential
losses.  During 2009 and into the first quarter of 2010, the Bank
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 2008 and 2009 has had a considerable impact on the ability of
certain borrowers to satisfy their obligations to the Bank, resulting in
continued watch list expansion, loan downgrades and corresponding increases in
loan loss provisions.  At March 31, 2010 the balance of loans the Bank
has graded “substandard” totaled approximately $82.5 million, of which
approximately $49.0 million were non-accruing.  When compared to the
$75.4 million in substandard balances as December 31, 2009, substandard balances
increased approximately $7.1 million.





The Bank
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 quarter ended March 31, 2010 totaled approximately $1.5 million, a
decline of approximately $0.6 million when compared to that reported for the
same period ended a year earlier.  For the first three months of 2010
net charge-offs to average loans were 0.14% compared to the 0.30% reported for
the same period ended a year ago.  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 quarter of 2010 continued in the categories of commercial and
industrial as well as construction.   Losses within these
segments in conjunction with an increase in the number and total dollar volume
of past due and non-accruing balances of such loans contributed further to the
additional provisions the Bank made to the allowance for loan losses during the
first quarter of 2010.  Continued increases in the level of
charge-offs, the number and dollar volume of past due 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.


Heritage
Oaks Bancorp | - 46 -








Management’s
Discussion and Analysis





Looking
forward into 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 there may be further
increases in the national unemployment rate, which will undoubtedly place
continued pressure on conditions within the Bank’s primary market
area.  Continued economic pressures may negatively impact the
financial condition of borrowers to whom the Bank has extended credit and as a
result the Bank may be required to make further significant provisions to the
allowance for loan losses during 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.


Heritage
Oaks Bancorp | - 47 -








Management’s
Discussion and Analysis





Financial
Condition





At March
31, 2010 total assets were $1.019 billion.  This when compared to the
$945.2 million reported at December 31, 2009, represents an increase of
approximately $74.3 million or 7.9%.  The increase in total assets is
primarily attributable to higher interest bearing due from balances, resulting
from the receipt of approximately $56.0 million in gross proceeds from the
Company’s March 2010 private placement and a $20.0 million increase in total
deposits.





At March
31, 2010, total deposits were approximately $795.4 million or approximately
$19.9 million higher than the $775.5 million reported at December 31,
2009.  Net of an $8.7 million pay-down in brokered funds, total
deposits increased approximately $28.6 million.  Deposit growth was
across all categories with the majority of the year to date increase
attributable to increases in non-interest bearing demand, money market balances
and time deposits.





Loans





At March
31, 2010 total gross loan balances were $722.7 million.  This
represents a decline of approximately $6.0 million or 0.8% 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
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 March 31, 2010:





March
      31,
                      
                      
                      December
      31,
                      
                      
                      Variance(dollars
      in thousands)
                      
                      2010
                      
                      
                      2009
                      
                      
                      dollar
                      
                      
                      percentageReal
      Estate SecuredMulti-family
      residential
                      
                      $
                      20,530
                      
                      
                      $
                      20,631
                      
                      
                      $
                      (101
                      )
                      
                      
                      -0.49
                      %Residential
      1 to 4 family
                      
                      
                      25,846
                      
                      
                      
                      25,483
                      
                      
                      
                      363
                      
                      
                      
                      1.42
                      %Home
      equity line of credit
                      
                      
                      29,383
                      
                      
                      
                      29,780
                      
                      
                      
                      (397
                      )
                      
                      
                      -1.33
                      %Commercial
                      
                      
                      335,733
                      
                      
                      
                      337,940
                      
                      
                      
                      (2,207
                      )
                      
                      
                      -0.65
                      %Farmland
                      
                      
                      12,804
                      
                      
                      
                      13,079
                      
                      
                      
                      (275
                      )
                      
                      
                      -2.10
                      %CommercialCommercial
      and industrial
                      
                      
                      152,291
                      
                      
                      
                      157,270
                      
                      
                      
                      (4,979
                      )
                      
                      
                      -3.17
                      %Agriculture
                      
                      
                      19,591
                      
                      
                      
                      17,698
                      
                      
                      
                      1,893
                      
                      
                      
                      10.70
                      %Other
                      
                      
                      238
                      
                      
                      
                      238
                      
                      
                      
                      -
                      
                      
                      
                      0.00
                      %ConstructionSingle
      family residential
                      
                      
                      15,732
                      
                      
                      
                      15,538
                      
                      
                      
                      194
                      
                      
                      
                      1.25
                      %Single
      family residential - Spec.
                      
                      
                      3,295
                      
                      
                      
                      3,400
                      
                      
                      
                      (105
                      )
                      
                      
                      -3.09
                      %Tract
                      
                      
                      1,245
                      
                      
                      
                      2,215
                      
                      
                      
                      (970
                      )
                      
                      
                      -43.79
                      %Multi-family
                      
                      
                      1,883
                      
                      
                      
                      2,300
                      
                      
                      
                      (417
                      )
                      
                      
                      -18.13
                      %Hospitality
                      
                      
                      13,126
                      
                      
                      
                      14,306
                      
                      
                      
                      (1,180
                      )
                      
                      
                      -8.25
                      %Commercial
                      
                      
                      30,704
                      
                      
                      
                      27,128
                      
                      
                      
                      3,576
                      
                      
                      
                      13.18
                      %Land
                      
                      
                      51,557
                      
                      
                      
                      52,793
                      
                      
                      
                      (1,236
                      )
                      
                      
                      -2.34
                      %Installment
      loans to individuals
                      
                      
                      8,407
                      
                      
                      
                      8,327
                      
                      
                      
                      80
                      
                      
                      
                      0.96
                      %All
      other loans (including overdrafts)
                      
                      
                      378
                      
                      
                      
                      553
                      
                      
                      
                      (175
                      )
                      
                      
                      -31.65
                      %Total
      loans, gross
                      
                      
                      722,743
                      
                      
                      
                      728,679
                      
                      
                      
                      (5,936
                      )
                      
                      
                      -0.81
                      %Deferred
      loan fees
                      
                      
                      1,699
                      
                      
                      
                      1,825
                      
                      
                      
                      (126
                      )
                      
                      
                      -6.89
                      %Reserve
      for possible loan losses
                      
                      
                      18,559
                      
                      
                      
                      14,372
                      
                      
                      
                      4,187
                      
                      
                      
                      29.13
                      %Total
      loans, net
                      
                      $
                      702,485
                      
                      
                      $
                      712,482
                      
                      
                      $
                      (9,997
                      )
                      
                      
                      -1.40
                      %Loans
      held for sale
                      
                      $
                      7,815
                      
                      
                      $
                      9,487
                      
                      
                      $
                      (1,672
                      )
                      
                      
                      -17.62
                      %


Heritage
Oaks Bancorp | - 48 -








Management’s
Discussion and Analysis





Real
Estate Secured





The
following table provides a break-down of the real estate secured segment of the
Bank’s loan portfolio as of March 31, 2010:





March 31, 2010
                      
                      
                      
                      
                      
                      Balance as Percent
                      
                      
                      
                      
                      
                      SingleUndisbursed
                      
                      
                      Total Bank
                      
                      
                      Percent
                      
                      
                      of Bank's Risk
                      
                      
                      Number
                      
                      
                      Largest(dollars in thousands)
                      
                      Balance
                      
                      
                      Commitment
                      
                      
                      Exposure
                      
                      
                      Composition
                      
                      
                      Based Capital
                      
                      
                      of Loans
                      
                      
                      LoanRetail
                      
                      $
                      40,261
                      
                      
                      $
                      2,491
                      
                      
                      $
                      42,752
                      
                      
                      
                      9.4
                      %
                      
                      
                      31.4
                      %
                      
                      
                      56
                      
                      
                      $
                      5,000Professional
                      
                      
                      81,079
                      
                      
                      
                      249
                      
                      
                      
                      81,328
                      
                      
                      
                      17.9
                      %
                      
                      
                      63.2
                      %
                      
                      
                      100
                      
                      
                      
                      10,000Hospitality
                      
                      
                      74,519
                      
                      
                      
                      202
                      
                      
                      
                      74,721
                      
                      
                      
                      16.5
                      %
                      
                      
                      58.1
                      %
                      
                      
                      87
                      
                      
                      
                      10,891Multi-family
                      
                      
                      20,530
                      
                      
                      
                      -
                      
                      
                      
                      20,530
                      
                      
                      
                      4.5
                      %
                      
                      
                      16.0
                      %
                      
                      
                      19
                      
                      
                      
                      4,066Home
      equity lines of credit
                      
                      
                      29,383
                      
                      
                      
                      20,565
                      
                      
                      
                      49,948
                      
                      
                      
                      11.0
                      %
                      
                      
                      22.9
                      %
                      
                      
                      316
                      
                      
                      
                      1,680Residential
      1 to 4 family
                      
                      
                      25,846
                      
                      
                      
                      4,172
                      
                      
                      
                      30,018
                      
                      
                      
                      6.6
                      %
                      
                      
                      20.2
                      %
                      
                      
                      75
                      
                      
                      
                      2,994Farmland
                      
                      
                      12,804
                      
                      
                      
                      614
                      
                      
                      
                      13,418
                      
                      
                      
                      3.0
                      %
                      
                      
                      10.0
                      %
                      
                      
                      26
                      
                      
                      
                      1,937Healthcare
      / medical
                      
                      
                      18,330
                      
                      
                      
                      59
                      
                      
                      
                      18,389
                      
                      
                      
                      4.1
                      %
                      
                      
                      14.3
                      %
                      
                      
                      34
                      
                      
                      
                      2,155Restaurants
      / food establishments
                      
                      
                      7,958
                      
                      
                      
                      -
                      
                      
                      
                      7,958
                      
                      
                      
                      1.8
                      %
                      
                      
                      6.2
                      %
                      
                      
                      28
                      
                      
                      
                      2,541Commercial
                      
                      
                      97,451
                      
                      
                      
                      1,047
                      
                      
                      
                      98,498
                      
                      
                      
                      21.7
                      %
                      
                      
                      76.0
                      %
                      
                      
                      126
                      
                      
                      
                      5,000Other
                      
                      
                      16,135
                      
                      
                      
                      40
                      
                      
                      
                      16,175
                      
                      
                      
                      3.5
                      %
                      
                      
                      12.6
                      %
                      
                      
                      27
                      
                      
                      
                      2,100Total
      real estate secured
                      
                      $
                      424,296
                      
                      
                      $
                      29,439
                      
                      
                      $
                      453,735
                      
                      
                      
                      100.0
                      %
                      
                      
                      330.9
                      %
                      
                      
                      894
                      
                      
                      $
                      48,364





As of
March 31, 2010, real estate secured balances represented approximately $424.3
million of total gross loans.  This when compared to the $426.9
million reported at December 31, 2009, represents a decline of approximately
$2.6 million or 0.6%.  The primary factor behind the year to date
decline can be attributed to several large pay-downs and pay-offs in the
commercial real estate segment of the portfolio.





At March
31, 2010, real estate secured balances represented 330.9% of the Bank’s total
risk-based capital.  When compared to that reported at December 31,
2009, real estate secured balances represented 524.1%.  Total
commitments as a percentage of the Bank’s total risk-based capital were 353.8%
at March 31, 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 March 2010 and subsequent
down-stream of $48.0 million to the Bank.





At March
31, 2010, approximately $170.8 million or 40.3% 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 some pressure on commercial real estate
prices within our market, primarily resulting from weakened economic
conditions.





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


Heritage
Oaks Bancorp | - 49 -








Management’s
Discussion and Analysis





Commercial





The
following table provides a break-down of the commercial and industrial segment
of the Bank’s commercial loan portfolio as of March 31, 2010:





March 31, 2010
                      
                      
                      
                      
                      
                      Balance as Percent
                      
                      
                      
                      
                      
                      SingleUndisbursed
                      
                      
                      Total Bank
                      
                      
                      Percent
                      
                      
                      of Bank's Risk
                      
                      
                      Number
                      
                      
                      Largest(dollars in thousands)
                      
                      Balance
                      
                      
                      Commitment
                      
                      
                      Exposure
                      
                      
                      Composition
                      
                      
                      Based Capital
                      
                      
                      of Loans
                      
                      
                      LoanAgriculture
                      
                      $
                      2,247
                      
                      
                      $
                      4,374
                      
                      
                      $
                      6,621
                      
                      
                      
                      3.0
                      %
                      
                      
                      1.8
                      %
                      
                      
                      31
                      
                      
                      $
                      2,000Oil
      / Gas and Utilities
                      
                      
                      1,319
                      
                      
                      
                      1,074
                      
                      
                      
                      2,393
                      
                      
                      
                      1.1
                      %
                      
                      
                      1.0
                      %
                      
                      
                      9
                      
                      
                      
                      1,200Construction
                      
                      
                      18,680
                      
                      
                      
                      15,723
                      
                      
                      
                      34,403
                      
                      
                      
                      15.8
                      %
                      
                      
                      14.6
                      %
                      
                      
                      164
                      
                      
                      
                      2,750Manufacturing
                      
                      
                      10,345
                      
                      
                      
                      9,572
                      
                      
                      
                      19,917
                      
                      
                      
                      9.2
                      %
                      
                      
                      8.1
                      %
                      
                      
                      99
                      
                      
                      
                      1,675Wholesale
      and Retail
                      
                      
                      14,213
                      
                      
                      
                      5,141
                      
                      
                      
                      19,354
                      
                      
                      
                      8.9
                      %
                      
                      
                      11.1
                      %
                      
                      
                      122
                      
                      
                      
                      1,250Transportation
      and Warehousing
                      
                      
                      2,192
                      
                      
                      
                      535
                      
                      
                      
                      2,727
                      
                      
                      
                      1.3
                      %
                      
                      
                      1.7
                      %
                      
                      
                      32
                      
                      
                      
                      596Media
      & Information Services
                      
                      
                      8,349
                      
                      
                      
                      1,981
                      
                      
                      
                      10,330
                      
                      
                      
                      4.7
                      %
                      
                      
                      6.5
                      %
                      
                      
                      25
                      
                      
                      
                      4,500Financial
      Services
                      
                      
                      10,962
                      
                      
                      
                      2,794
                      
                      
                      
                      13,756
                      
                      
                      
                      6.3
                      %
                      
                      
                      8.5
                      %
                      
                      
                      44
                      
                      
                      
                      5,866Real-Estate
      / Rental and Leasing
                      
                      
                      17,168
                      
                      
                      
                      7,550
                      
                      
                      
                      24,718
                      
                      
                      
                      11.4
                      %
                      
                      
                      13.4
                      %
                      
                      
                      90
                      
                      
                      
                      3,500Professional
      Services
                      
                      
                      17,020
                      
                      
                      
                      5,627
                      
                      
                      
                      22,647
                      
                      
                      
                      10.4
                      %
                      
                      
                      13.3
                      %
                      
                      
                      142
                      
                      
                      
                      1,939Healthcare
      / Medical & Social Services
                      
                      
                      18,725
                      
                      
                      
                      6,769
                      
                      
                      
                      25,494
                      
                      
                      
                      11.7
                      %
                      
                      
                      14.6
                      %
                      
                      
                      110
                      
                      
                      
                      11,355Restaurants
      and Hospitality
                      
                      
                      25,452
                      
                      
                      
                      3,175
                      
                      
                      
                      28,627
                      
                      
                      
                      13.2
                      %
                      
                      
                      19.8
                      %
                      
                      
                      120
                      
                      
                      
                      6,000All
      Other
                      
                      
                      5,619
                      
                      
                      
                      985
                      
                      
                      
                      6,604
                      
                      
                      
                      3.0
                      %
                      
                      
                      4.4
                      %
                      
                      
                      58
                      
                      
                      
                      1,200Commercial
      and industrial
                      
                      $
                      152,291
                      
                      
                      $
                      65,300
                      
                      
                      $
                      217,591
                      
                      
                      
                      100.0
                      %
                      
                      
                      118.8
                      %
                      
                      
                      1,046
                      
                      
                      $
                      43,831





At March
31, 2010, commercial and industrial loans represented approximately $152.3
million of total gross loan balances.  This when compared to the
$157.3 million reported at December 31, 2009, represents a decline of
approximately $5.0 million or 3.2%.  The year to date decline can be
attributed to a large number of pay-downs of various business lines of credit in
amounts ranging from $0.2 million to $0.7 million.  Slightly
offsetting these declines was the funding of several new loans in amounts
ranging from $0.3 million to $0.6 million, totaling approximately $2.1
million.





At March
31, 2010 total commercial and industrial balances represented 118.8% 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 169.6%, 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 March 2010 and subsequent
down-stream of $48.0 million to the Bank.





At March
31, 2010 agriculture balances totaled approximately $19.6 million, which
represents an approximate $1.9 million increase when compared to the $17.7
million reported at December 31, 2009.  The year to date increase
within this category can be attributed to one new loan funded during the first
quarter for approximately $1.3 million.


Heritage
Oaks Bancorp | - 50 -







Management’s
Discussion and Analysis




Construction





The
following table provides a break-down of the construction segment of the Bank’s
loan portfolio as of March 31, 2010:





March 31, 2010
                
                
                
                
                
                Balance as Percent
                
                
                
                
                
                SingleUndisbursed
                
                
                Total Bank
                
                
                Percent
                
                
                of Bank's Risk
                
                
                Number
                
                
                Largest(dollars in thousands)
                
                Balance
                
                
                Commitment
                
                
                Exposure
                
                
                Composition
                
                
                Based Capital
                
                
                of Loans
                
                
                LoanSingle
      family residential
                
                $
                15,732
                
                
                $
                6,183
                
                
                $
                21,915
                
                
                
                26.5
                %
                
                
                12.3
                %
                
                
                22
                
                
                $
                4,600Single
      family residential - Spec.
                
                
                3,295
                
                
                
                1,458
                
                
                
                4,753
                
                
                
                5.7
                %
                
                
                2.6
                %
                
                
                6
                
                
                
                1,750Tract
                
                
                1,245
                
                
                
                -
                
                
                
                1,245
                
                
                
                1.5
                %
                
                
                1.0
                %
                
                
                7
                
                
                
                525Multi-family
                
                
                1,883
                
                
                
                100
                
                
                
                1,983
                
                
                
                2.4
                %
                
                
                1.5
                %
                
                
                2
                
                
                
                1,500Commercial
                
                
                30,704
                
                
                
                9,036
                
                
                
                39,740
                
                
                
                48.0
                %
                
                
                23.9
                %
                
                
                19
                
                
                
                6,720Hospitality
                
                
                13,126
                
                
                
                -
                
                
                
                13,126
                
                
                
                15.9
                %
                
                
                10.2
                %
                
                
                2
                
                
                
                7,359Total
      construction
                
                $
                65,985
                
                
                $
                16,777
                
                
                $
                82,762
                
                
                
                100.0
                %
                
                
                51.5
                %
                
                
                58
                
                
                $
                22,454





At March
31, 2010, construction balances represented approximately $66.0 million or 9.1%
of total gross loan balances.  This when compared to the $64.9 million
or 8.9% reported at December 31, 2009 represents an increase of approximately
$1.1 million.  The increase in construction balances can be attributed
to several large advances on existing projects in the commercial category of the
construction portfolio.  Offsetting the increase in this category of
commercial construction were pay-downs of several non-accruing loans in the
tract construction category as well as the partial charge-off of one loan in the
multi-family construction category.  Also offsetting increases in
commercial construction balances was the move of one hospitality construction
loan to the commercial real estate segment of the portfolio.





At March
31, 2010 total construction balances represented approximately 51.5% of the
Bank’s total risk-based capital.  This compares to the 79.7% reported
at December 31, 2009.  Total construction commitments represented
64.5% of the Bank’s total risk-based capital at March 31, 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 March 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 Bank’s loan
portfolio as of March 31, 2010:





March 31, 2010
                  
                  
                  
                  
                  
                  Balance as Percent
                  
                  
                  
                  
                  
                  SingleUndisbursed
                  
                  
                  Total Bank
                  
                  
                  Percent
                  
                  
                  of Bank's Risk
                  
                  
                  Number
                  
                  
                  Largest(dollars in thousands)
                  
                  Balance
                  
                  
                  Commitment
                  
                  
                  Exposure
                  
                  
                  Composition
                  
                  
                  Based Capital
                  
                  
                  of Loans
                  
                  
                  LoanSingle
      family residential
                  
                  $
                  6,711
                  
                  
                  $
                  -
                  
                  
                  $
                  6,711
                  
                  
                  
                  12.6
                  %
                  
                  
                  5.2
                  %
                  
                  
                  29
                  
                  
                  $
                  1,000Single
      family residential - Spec.
                  
                  
                  1,840
                  
                  
                  
                  -
                  
                  
                  
                  1,840
                  
                  
                  
                  3.4
                  %
                  
                  
                  1.4
                  %
                  
                  
                  7
                  
                  
                  
                  618Tract
                  
                  
                  26,743
                  
                  
                  
                  -
                  
                  
                  
                  26,743
                  
                  
                  
                  50.0
                  %
                  
                  
                  20.9
                  %
                  
                  
                  10
                  
                  
                  
                  10,673Multi-family
                  
                  
                  1,312
                  
                  
                  
                  -
                  
                  
                  
                  1,312
                  
                  
                  
                  2.5
                  %
                  
                  
                  1.0
                  %
                  
                  
                  3
                  
                  
                  
                  3,584Commercial
                  
                  
                  11,112
                  
                  
                  
                  1,858
                  
                  
                  
                  12,970
                  
                  
                  
                  24.3
                  %
                  
                  
                  8.7
                  %
                  
                  
                  21
                  
                  
                  
                  1,500Hospitality
                  
                  
                  3,839
                  
                  
                  
                  -
                  
                  
                  
                  3,839
                  
                  
                  
                  7.2
                  %
                  
                  
                  3.0
                  %
                  
                  
                  4
                  
                  
                  
                  2,340Total
      land
                  
                  $
                  51,557
                  
                  
                  $
                  1,858
                  
                  
                  $
                  53,415
                  
                  
                  
                  100.0
                  %
                  
                  
                  40.2
                  %
                  
                  
                  74
                  
                  
                  $
                  19,715





At March
31, 2010, land balances represented approximately $51.6 million or 7.1% of total
gross loan balances.  When compared to the $52.8 million reported at
December 31, 2009, land balances declined approximately $1.2
million.  The year to date decline can be attributed in large part to
a $1.0 million pay-down of one loan previously placed on
non-accrual.





The
single largest loan within this category is for a residential tract development
and carries a balance of approximately $10.7 million at March 31,
2010.    This project, while located in Kern County of the
California Central Valley is for a client within the Bank’s primary market area.
The project was funded in the first quarter of 2008 and had an approximate loan
to value of 50.0%, based on an appraisal conducted at the
time.  During the ground grading process as the property was being
developed, the client discovered that there was considerable value in the rock
and as a result has begun to develop a rock quarry operation on part of the
development site. The Bank has had the value of the property and quarry
operation appraised recently, which indicated there was more than adequate value
to cover the Bank’s recorded investment in the loan.  The Bank is in
the process of creating separate purpose financing for the quarry
operation.   Additionally, recent indications suggest the
financial condition of the borrower continues to remain sound.







Heritage
Oaks Bancorp | - 51 -


Management’s
Discussion and Analysis




At March
31, 2010 total land loan balances represented 40.2% of the Bank’s total
risk-based capital compared to the 64.8% reported at December 31,
2009.  Total land commitments represented approximately 41.6% of the
Bank’s total-risked based capital at March 31, 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 March
2010 and subsequent down-stream of $48.0 million to the Bank.





Installment





At March
31, 2010, the installment loan balances were approximately $8.4
million.  This, when compared to the $8.3 million reported at December
31, 2009, represents an increase of approximately $0.1
million.  Installment loans include revolving credit plans, consumer
loans, as well as credit card balances obtained in the acquisition of Business
First.





Loans
Held for Sale





Loans
held for sale consist of mortgage originations that have already been sold
pursuant to correspondent mortgage loan agreements. There is no interest rate
risk associated with these loans as the commitments are in place at the time the
Bank funds them. Settlement from the correspondents is typically within 30 to 45
days.  At March 31, 2010 mortgage correspondent loans (loans held for
sale) totaled approximately $7.8 million.  This when compared to the
$9.5 million reported at December 31, 2009, represents a decline of
approximately $1.7 million.  The dramatic year over year decline in
interest rates has lead to significantly higher mortgage re-financing volumes,
which combined with the Bank’s expansion of its mortgage origination department
to further the Bank’s penetration its market, have contributed substantially to
the year to date increase within this category.





Foreign
Loans





At March
31, 2010 the Bank had no foreign loans outstanding.





Summary
of Market Condition





Prices of
single family homes have fallen significantly from market highs seen in 2007 in
California as a whole.  Along with other segments in the real estate
sector, commercial real estate prices in the Company’s market area experienced
pressure during the last year and the Company has begun to see increases in
vacancy rates in certain retail, industrial and office segments.  The
most recent data available to the Company shows vacancy rates within retail,
industrial and office segments to be approximately 5.6%, 6.1% and 9.7%,
respectively as of the third quarter of 2009.  This compares to 3.0%,
5.4% and 6.1%, respectively as of the third quarter of 2008.  The
Company realizes that any prolonged and significant downturn in the national,
state and local economies may further impact the values of commercial real
estate within its market footprint as well as the borrowers to whom the Bank has
extended such credit and as such vacancy rates may increase in future
periods.  As such, Management continues to closely monitor the credits
within this segment of the loan portfolio for potential signs of
deterioration.  Additionally, the Bank is aware that as economic
conditions worsen and levels of unemployment continue to rise, borrowers to whom
the Bank has extended commercial lines of credit may come under additional
pressure to satisfy their outstanding obligations.  That said, the
Bank continues to employ stringent lending standards and remains very selective
with regard to any additional commercial real estate, real estate construction,
land and commercial loans it chooses to originate in an effort to effectively
manage risk in this difficult credit environment.





Although,
the Company’s market footprint has historically enjoyed a more stable level of
economic growth, the Company has not been immune to the effects of a slowdown on
a state or national level.  As previously mentioned, with the effects
of a weakened economy placing more pressure on borrowers, the ability of
consumers to satisfy outstanding obligations to the financial sector, as a
whole, has been impacted.  We believe that within certain areas of our
local economy these more macro level concerns have become more
evident.  This has had an impact on the level of and type of loans the
Bank has placed on non-accrual and charged-off during the last two
years.  Additionally, the Company has devoted considerable resources
to the monitoring of credits within the loan portfolio in order to take any
appropriate steps when and if necessary to mitigate any material adverse impact
the effects of weakened economic conditions may have on the Bank
overall.


Heritage
Oaks Bancorp | - 52 -


Management’s
Discussion and Analysis
  As of
March 31, 2010, a substantial portion of loans the Bank originated within the
major categories of commercial real estate, construction, land, and commercial
and industrial were made to borrowers within our current market
footprint.




Credit
Quality





While the
Bank continues to adhere to prudent underwriting standards, the credit quality
of the Bank’s loan portfolio is impacted by numerous factors, including the
economic environment in the markets in which it operates and its impact on real
estate prices securing collateral dependent loans in the Bank’s loan
portfolio.  Weakened economic conditions have had, and if continue to
persist, may further impact real estate used as collateral for certain loans the
Bank has made.  Additionally, weak economic conditions have impacted
certain borrowers to who the Bank has extended credit, making it difficult and
in some cases impossible for those borrowers to continue to make scheduled loan
payments.  An inability of certain borrowers to continue to perform
under the original terms of their respective loan agreements in conjunction with
declines in collateral values has resulted in, and if such conditions continue,
may result in further, increases in provisions for loan losses and have an
adverse impact on the Company’s operating results.





In an
effort to manage credit quality the Bank monitors loans in the portfolio with
the assistance of a semi-annual independent loan review to identify and mitigate
any potential credit quality issues and losses in a proactive
manner.  Management’s review in conjunction with the semi-annual
independent review focuses on non-watch related credits within certain pools of
loans that may be expected to experience stress due to economic
conditions.  This process allows the Bank to validate credit ratings,
underwriting structure and the Bank’s estimated exposure in the current economic
environment and enhance communications with borrowers where necessary ultimately
in an effort to mitigate potential losses to the Bank.





The
current lending environment has proven to be difficult for the
Bank.  Significantly weakened economic conditions have resulted in a
considerable increase in the number and dollar volume of past due loans as well
as loans the Bank has placed on non-accrual during the year.  In
response to these conditions, the Bank formed a Special Assets department in
2008, which has subsequently been expanded.  This area of the Bank not
only monitors loans that have been classified as non-performing and/or groups of
loans that have been downgraded in order to enhance communications with
borrowers, assist in the “work-out” of certain credits, more closely monitor
collateral, and determine the Bank’s exposure to such
relationships.





Allowance
for Loan Losses





The Bank
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 that the Bank will be
unable to collect all amounts due according to the contractual terms of the loan
agreement.  The Bank may also consider a loan impaired when based on
certain information and events surrounding a borrower, it is determined that the
likelihood of the Bank receiving all scheduled payments, including interest,
when due is remote.  Once a loan is classified as impaired, the Bank
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 Bank typically establishes a
corresponding valuation allowance, which then becomes a component of the Bank’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 Bank’s prior experience with such loans.







Heritage
Oaks Bancorp | - 53 -


Management’s
Discussion and Analysis




Subjectively
Determined Allocation





The
subjectively determined allocation of the allowance is determined by estimates
the Bank 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 Bank’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 Bank’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 Bank’s allowance for
loan losses.





The
allowance for loan losses increased in the first quarter of 2010 over that
reported as of December 31, 2009, due to several factors including: continued
weakness in the economy, an increase in the number of and dollar volume of
non-performing loans and an increase in the balance of classified
loans.  At March 31, 2010 the balance of classified loans was
approximately $82.5 million.  This compares to the $75.4 million in
classified loan balances reported at December 31, 2009.   The
year to date increase in substandard balances resulted in higher required
balances in the general portfolio allocation under the Bank’s methodology for
determining an appropriate level for the allowance for loan
losses.  Elevated charge-offs also contributed to the higher required
balances of the general portfolio allocation of the
allowance.  Additionally, continued weakened economic conditions as
well as negative trends in credit quality resulted in higher required balances
of the subjectively determined allocation of the allowance.  As a
result of the items mentioned the Bank made provisions to the allowance for loan
losses in the amount of $5.2 million during the first quarter of 2010, compared
to provisions of approximately $2.1 million during the same period ended a year
earlier.  As a result the allowance for loan losses at March 31, 2010
was approximately $18.6 million compared to the $14.4 million reported at
December 31, 2009, an increase of approximately $4.2 million or 29.2% during the
first quarter of 2010.





Loans
charged-off during the first three months ended March 31, 2010 totaled
approximately $1.5 million compared to the $2.1 million reported for the same
period ended a year earlier.  Net charge-offs to average loans for the
three months ended March 31, 2010 and 2009 were 0.14% and 0.30%,
respectively.  At March 31, 2010 the allowance for loan losses
represented 2.57% of total gross loans compared to the 1.97% reported at
December 31, 2009.





As of
March 31, 2010 Management believes the allowance for loan losses was sufficient
to cover current estimable losses in the Bank’s loan portfolio.







Heritage
Oaks Bancorp | - 54 -


Management’s
Discussion and Analysis




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:





March 31,
                      
                      
                      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
                      
                      $
                      119
                      
                      
                      
                      2.8
                      %
                      
                      $
                      36
                      
                      
                      
                      2.5
                      %
                      
                      $
                      119
                      
                      
                      
                      2.8
                      %Residential
      1 to 4 family
                      
                      
                      560
                      
                      
                      
                      3.6
                      %
                      
                      
                      148
                      
                      
                      
                      3.3
                      %
                      
                      
                      264
                      
                      
                      
                      3.5
                      %Home
      equity line of credit
                      
                      
                      174
                      
                      
                      
                      4.1
                      %
                      
                      
                      97
                      
                      
                      
                      4.2
                      %
                      
                      
                      179
                      
                      
                      
                      4.1
                      %Commercial
                      
                      
                      6,274
                      
                      
                      
                      46.4
                      %
                      
                      
                      5,103
                      
                      
                      
                      42.6
                      %
                      
                      
                      6,081
                      
                      
                      
                      46.5
                      %Farmland
                      
                      
                      850
                      
                      
                      
                      1.8
                      %
                      
                      
                      430
                      
                      
                      
                      1.4
                      %
                      
                      
                      208
                      
                      
                      
                      1.8
                      %CommercialCommercial
      and industrial
                      
                      
                      5,576
                      
                      
                      
                      21.0
                      %
                      
                      
                      3,013
                      
                      
                      
                      24.2
                      %
                      
                      
                      4,635
                      
                      
                      
                      21.6
                      %Agriculture
                      
                      
                      1,681
                      
                      
                      
                      2.7
                      %
                      
                      
                      141
                      
                      
                      
                      2.0
                      %
                      
                      
                      178
                      
                      
                      
                      2.4
                      %Other
                      
                      
                      1
                      
                      
                      
                      0.0
                      %
                      
                      
                      7
                      
                      
                      
                      0.1
                      %
                      
                      
                      1
                      
                      
                      
                      0.0
                      %ConstructionSingle
      family residential
                      
                      
                      270
                      
                      
                      
                      2.2
                      %
                      
                      
                      86
                      
                      
                      
                      2.4
                      %
                      
                      
                      304
                      
                      
                      
                      2.1
                      %Single
      family residential - Spec.
                      
                      
                      49
                      
                      
                      
                      0.5
                      %
                      
                      
                      120
                      
                      
                      
                      1.9
                      %
                      
                      
                      46
                      
                      
                      
                      0.5
                      %Tract
                      
                      
                      71
                      
                      
                      
                      0.2
                      %
                      
                      
                      17
                      
                      
                      
                      0.5
                      %
                      
                      
                      190
                      
                      
                      
                      0.3
                      %Multi-family
                      
                      
                      15
                      
                      
                      
                      0.3
                      %
                      
                      
                      279
                      
                      
                      
                      0.8
                      %
                      
                      
                      90
                      
                      
                      
                      0.3
                      %Hospitality
                      
                      
                      99
                      
                      
                      
                      1.8
                      %
                      
                      
                      45
                      
                      
                      
                      1.2
                      %
                      
                      
                      107
                      
                      
                      
                      2.0
                      %Commercial
                      
                      
                      567
                      
                      
                      
                      4.2
                      %
                      
                      
                      127
                      
                      
                      
                      3.0
                      %
                      
                      
                      270
                      
                      
                      
                      3.7
                      %Land
                      
                      
                      2,198
                      
                      
                      
                      7.1
                      %
                      
                      
                      762
                      
                      
                      
                      8.7
                      %
                      
                      
                      1,644
                      
                      
                      
                      7.2
                      %Installment
      loans to individuals
                      
                      
                      43
                      
                      
                      
                      1.2
                      %
                      
                      
                      16
                      
                      
                      
                      1.2
                      %
                      
                      
                      40
                      
                      
                      
                      1.1
                      %All
      other loans (including overdrafts)
                      
                      
                      12
                      
                      
                      
                      0.1
                      %
                      
                      
                      2
                      
                      
                      
                      0.0
                      %
                      
                      
                      16
                      
                      
                      
                      0.1
                      %Total
      allowance for loan losses
                      
                      $
                      18,559
                      
                      
                      
                      100.0
                      %
                      
                      $
                      10,429
                      
                      
                      
                      100.0
                      %
                      
                      $
                      14,372
                      
                      
                      
                      100.0
                      %





Non-Performing
Assets





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





The Bank
has a non-accrual policy that requires a loan greater than 90 days past due
and/or 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 Bank’s “substandard” risk
grade.  When a loan is first classified as substandard, the Bank
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 Bank’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
on such loan have been charged-off.  The Bank 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.







Heritage
Oaks Bancorp | - 55 -


Management’s
Discussion and Analysis




If a
complete appraisal will take a significant amount of time to complete, while
waiting for an appraisal the Bank may also rely on a broker’s price opinion or
other meaningful market data, such as comparables, 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 Bank generally takes steps to protect and
liquidate the collateral.  Any loss resulting from the difference
between the loan balance and the fair market value of the collateral is
recognized by a charge to the allowance for loan losses.  When
collateral is held for sale after foreclosure, it is subject to a periodic
appraisal.  If the appraisal indicates that the collateral will sell
for less than its recorded value, the Bank recognizes the loss by a charge to
non-interest expense.





Negative
undertones associated with the economy and real estate markets have resulted in
the expansion of the Bank’s internal watch list as well as the number of and
dollar volume of non-accruing loans over the last year.  While credit
quality is consistently monitored, Management has implemented additional
precautionary actions that include but are not limited to pro-actively
identifying credit weaknesses earlier in the collection cycle, increasing the
oversight frequency of watch list credits and devoting additional internal
resources to monitor those credits.  Although the Bank believes these
actions will serve to potentially minimize any future losses the Bank may incur
related to problem loans, we cannot guarantee that the Bank will not experience
an increase in non-performing loans, given continued uncertainties surrounding
the state and national economies.





As
evidenced in the table below summarizing the Bank’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.





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





March 31,
                      
                      
                      December 31,
                      
                      
                      Variance(dollars in thousands)
                      
                      2010
                      
                      
                      2009
                      
                      
                      Dollar
                      
                      
                      PercentLoans
      delinquent 90 days or more and still accruing
                      
                      $
                      -
                      
                      
                      $
                      151
                      
                      
                      $
                      (151
                      )
                      
                      
                      -100.00
                      %Non-Accruing
      LoansCommercial
      real estate
                      
                      
                      14,310
                      
                      
                      $
                      11,035
                      
                      
                      
                      3,275
                      
                      
                      
                      29.68
                      %Residential
      1-4 family
                      
                      
                      1,145
                      
                      
                      
                      1,147
                      
                      
                      
                      (2
                      )
                      
                      
                      -0.17
                      %Home
      equity lines of credit
                      
                      
                      320
                      
                      
                      
                      320
                      
                      
                      
                      -
                      
                      
                      
                      0.00
                      %Farmland
                      
                      
                      2,704
                      
                      
                      
                      -
                      
                      
                      
                      2,704
                      
                      
                      
                      100.00
                      %Commercial
      and industrial
                      
                      
                      9,740
                      
                      
                      
                      8,429
                      
                      
                      
                      1,311
                      
                      
                      
                      15.55
                      %Agriculture
                      
                      
                      3,493
                      
                      
                      
                      3,172
                      
                      
                      
                      321
                      
                      
                      
                      10.12
                      %Construction
                      
                      
                      3,351
                      
                      
                      
                      3,838
                      
                      
                      
                      (487
                      )
                      
                      
                      -12.69
                      %Land
                      
                      
                      13,839
                      
                      
                      
                      10,182
                      
                      
                      
                      3,657
                      
                      
                      
                      35.92
                      %Installment
                      
                      
                      81
                      
                      
                      
                      47
                      
                      
                      
                      34
                      
                      
                      
                      72.34
                      %Total
      non-accruing loans
                      
                      $
                      48,983
                      
                      
                      $
                      38,170
                      
                      
                      $
                      10,813
                      
                      
                      
                      28.33
                      %Other
      real estate owned
                      
                      $
                      741
                      
                      
                      $
                      946
                      
                      
                      $
                      (205
                      )
                      
                      
                      -21.67
                      %Total
      non-performing assets
                      
                      $
                      49,724
                      
                      
                      $
                      39,267
                      
                      
                      $
                      10,457
                      
                      
                      
                      26.63
                      %Ratio
      of allowance for credit losses to total gross loans
                      
                      
                      2.57
                      %
                      
                      
                      1.97
                      %Ratio
      of allowance for credit losses to total non-performing
    loans
                      
                      
                      37.89
                      %
                      
                      
                      37.50
                      %Ratio
      of non-performing loans to total gross loans
                      
                      
                      6.78
                      %
                      
                      
                      5.26
                      %Ratio
      of non-performing assets to total assets
                      
                      
                      4.88
                      %
                      
                      
                      4.15
                      %





At March
31, 2010 the balance of non-accruing loans was approximately $49.0 million or
$10.8 million higher than the $38.2 million reported at December 31,
2009.  Notable changes in the balance of non-accruing loans occurred
within the categories of commercial real estate, farmland, commercial and
industrial and land.  The increases in the categories mentioned can be
attributed to several large loans moving to non-accrual during the first quarter
of 2010.







Heritage
Oaks Bancorp | - 56 -


Management’s
Discussion and Analysis




As
indicated in the table below, the Bank received payments on non-accruing loans
of approximately $2.4 million during the first three months of 2010, which can
be attributed in part to work-outs with borrowers as well as funds the Bank
received from the sale collateral securing such loans.  Charge-offs
during the first three months of the year totaled approximately $1.5 million,
the majority of which occurred in the categories of commercial and industrial
and construction.   Partially offsetting the increase in
non-accruing balances were two loans totaling approximately $2.1 million that
the Bank returned to accruing status after working with the respective
borrowers.





Non-performing
assets totaled approximately $49.7 million at March 31, 2010, approximately
$10.5 million higher than that reported at December 31, 2009.





The
following table reconciles the change in non accruing balances for the three
months ended March 31, 2010:





Balance
                      
                      
                      Additions to
                      
                      
                      
                      
                      
                      Transfers
                      
                      
                      Returns to
                      
                      
                      
                      
                      
                      BalanceDecember 31,
                      
                      
                      Non-Accruing
                      
                      
                      Net
                      
                      
                      to Foreclosed
                      
                      
                      Preforming
                      
                      
                      
                      
                      
                      March 31,(dollars in thousands)
                      
                      2009
                      
                      
                      Balances
                      
                      
                      Paydowns
                      
                      
                      Collateral
                      
                      
                      Status
                      
                      
                      Charge-offs
                      
                      
                      2010Real
      Estate SecuredMulti-family
      residential
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      -
                      
                      
                      $
                      -Residential
      1 to 4 family
                      
                      
                      1,147
                      
                      
                      
                      -
                      
                      
                      
                      (2
                      )
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      1,145Home
      equity line of credit
                      
                      
                      320
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      320Commercial
                      
                      
                      11,035
                      
                      
                      
                      5,179
                      
                      
                      
                      (216
                      )
                      
                      
                      -
                      
                      
                      
                      (1,688
                      )
                      
                      
                      -
                      
                      
                      
                      14,310Farmland
                      
                      
                      -
                      
                      
                      
                      2,704
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      
                      
                      
                      
                      -
                      
                      
                      
                      2,704CommercialCommercial
      and industrial
                      
                      
                      8,429
                      
                      
                      
                      2,803
                      
                      
                      
                      (543
                      )
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (949
                      )
                      
                      
                      9,740Agriculture
                      
                      
                      3,172
                      
                      
                      
                      475
                      
                      
                      
                      (154
                      )
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      3,493Other
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -ConstructionSingle
      family residential
                      
                      
                      940
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      940Single
      family residential - Spec.
                      
                      
                      683
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      683Tract
                      
                      
                      2,215
                      
                      
                      
                      -
                      
                      
                      
                      (470
                      )
                      
                      
                      -
                      
                      
                      
                      (454
                      )
                      
                      
                      (46
                      )
                      
                      
                      1,245Multi-family
                      
                      
                      -
                      
                      
                      
                      900
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (417
                      )
                      
                      
                      483Hospitality
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Commercial
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Land
                      
                      
                      10,182
                      
                      
                      
                      4,685
                      
                      
                      
                      (1,028
                      )
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      13,839Installment
      loans to individuals
                      
                      
                      47
                      
                      
                      
                      133
                      
                      
                      
                      (1
                      )
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (98
                      )
                      
                      
                      81All
      other loans
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      -Totals
                      
                      $
                      38,170
                      
                      
                      $
                      16,879
                      
                      
                      $
                      (2,414
                      )
                      
                      $
                      -
                      
                      
                      $
                      (2,142
                      )
                      
                      $
                      (1,510
                      )
                      
                      $
                      48,983





The
following provides additional information regarding non-accruing loan balances
as of March 31, 2010:





Real
Estate Secured – Commercial (“CRE”)





The
majority of balances within this category can be attributed to eleven loans to
seven borrowers, totaling approximately $12.4 million, representing 86.8% of
non-accruing CRE balances.  During the first quarter of 2010, the Bank
added approximately $5.2 million in CRE balances to non-accrual and returned
approximately $1.7 million in balances to accruing status after restructuring
the related loans and receiving sustained repayment performance from the
borrower.  The following provides a break-down of these balances as of
March 31, 2010:





·
            Approximately
      $1.4 million can be attributed to one loan in which the Bank is working
      with the borrower to bring it current.  Recent data suggests
      that the borrower’s financial condition is sound.  The borrower
      is also working to sell other assets to pay-down the loan.  This
      loan paid down approximately $0.1 million during the first three months of
      2010.


·
            Two
      loans made to two separate borrowers totaling approximately $1.8 million
      that the Bank has extended.  A third party has expressed
      interest in assuming responsibility for these notes and the Bank
      anticipates these notes to pay-down sometime during the first half of
      2010.


·
            Two
      loans totaling approximately $1.6 million made to one borrower are
      currently paying as agreed.  Based on the borrower’s recent
      performance and financial condition, the Bank currently anticipates these
      loans will move back to performing status sometime during the second
      quarter of 2010.


·
            The
      Bank currently anticipates receiving proceeds from the sale of collateral
      securing two loans to one borrower totaling approximately $1.1 million
      during the first half of 2010.


·
            One
      loan totaling approximately $0.9 million, secured by commercial property
      in the Bank’s primary market area.  The Bank is working with the
      bankruptcy trustee to liquidate the collateral and pay-down the
      loan.


·
            One
      loan totaling approximately $0.7 million.  The borrower is
      currently paying on the loan and recent financial information concerning
      the borrower indicates the borrower currently has the cash flow to
      continue to service the loan.







Heritage
Oaks Bancorp | - 57 -


Management’s
Discussion and Analysis




·
            Two
      loans to one borrower totaling approximately $4.9 million.  As
      previously discussed, the borrower is currently seeking alternative
      financing to pay-down their outstanding obligation to the
      Bank.  However, the Bank is proceeding with the foreclosure
      process.





Commercial
and Industrial (“C&I”)





The
majority of C&I balances can be attributed to ten loans to eight borrowers
totaling approximately $7.6 million or 78.8% of total C&I non-accruing
balances.  The Bank added approximately $2.8 million in C&I
balances to non-accruing status during the first three months of 2010, the
majority of which can be attributed to one loan in the amount of $1.3
million.  Contributing further to the quarter over quarter change in
non-accruing balances within this category were pay-downs of approximately $0.5
million as well as the charge-off of several smaller business lines of
credit.  The following provides a break-down of these balances as of
March 31, 2010:





·
            One
      loan in the approximate amount of $0.1 million is secured by real estate
      in the Bank’s primary market as well as various business
      assets.  Recent financial information concerning the client
      indicates the borrower currently has the cash flow to continue to service
      the loan.


·
            Three
      loans to one borrower totaling approximately $0.9 million.  The
      underlying collateral represents leased residential real
      estate.  The Bank is in the process of taking possession of the
      collateral and its rent proceeds to liquidate and pay-down the
      loan.


·
            One
      loan in the approximate amount of $0.4 million.  The borrower
      has been paying as agreed.  The Bank currently anticipates the
      loan to move back to performing status sometime during the second quarter
      of 2010.


·
            One
      loan in the approximate amount of $0.4 million contains an SBA
      guarantee.  Physical collateral has been repossessed and is
      being liquidated.


·
            One
      loan in the approximate amount of $0.5 million is secured by real estate
      in the Bank’s primary market area. The Bank is working with the bankruptcy
      trustee to liquidate collateral and pay-down the
  loan.


·
            One
      loan in the approximate amount of $0.5 million.  The Bank has
      entered into forbearance with the borrower and the borrower is making
      payments while attempting to re-finance with another institution or sell
      the underlying business.


·
            One
      loan in the approximate amount of $3.6 million is secured by real estate
      in the Bank’s primary market area.  A recent appraisal indicates
      its value is sufficient to cover the carrying value of the
      loan.  The Bank continues to work towards liquidation of the
      collateral.


·
            One
      loan in the approximate amount of $1.3 million.  The Bank is
      currently working with the borrower to bring about a
      resolution.  The loan is collateralized by various business
      assets.





Construction





Comprising
a majority of construction balances are nine loans to four borrowers totaling
approximately $3.1 million or 91.1% of non-accruing construction
balances.  Several loans totaling approximately $0.8 million have
pre-approved purchase contracts in place and Management currently anticipates
closings to occur during the second quarter of 2010. During the first quarter
the Bank received approximately $0.5 million in principal payments related to
closings on properties constructed by this particular
borrower.  Several other loans are secured by finished tract, spec and
single family residential construction.  The Bank is in the process of
obtaining possession of the collateral to liquidate and pay-down the related
loans.  During the first quarter the Bank placed a loan in the amount
of $0.9 million on non-accrual and subsequently charged-off approximately $0.4
million following the receipt of appraisal.  The Bank is in the
process of taking possession of the collateral to liquidate and pay-down the
loan





Land





Balances
within this category can be attributed in large part to nine loans to seven
borrowers totaling approximately $12.7 million or 91.9% of total non-accruing
land balances.  During the quarter the Bank placed one loan in the
amount of $4.4 million on non-accrual.  Partially offsetting this
increase were pay-downs in the aggregate amount of $1.0 million, primarily
attributable to one loan.  The following provides a break-down of
these balances as of March 31, 2010:





·
            Three
      loans to two borrowers totaling approximately $2.9 million representing
      land for residential tract development.  The Bank is currently
      working to take possession of and liquidate the
  collateral.


·
            Two
      loans to one borrower totaling approximately $1.3 million representing
      land within the Bank’s primary market area.  The Bank is
      currently in negotiation with the borrower to take possession of the
      collateral and liquidate it.


·
            One
      loan totaling approximately $1.1 million.  A third party has
      expressed interest in assuming responsibility for the loan.  The
      Bank currently anticipates the loan to pay-down during the second quarter
      of 2010







Heritage
Oaks Bancorp | - 58 -


Management’s
Discussion and Analysis




·
            One
      loan totaling approximately $2.0 million secured by land for hospitality
      construction in the Bank’s primary market area.  The Bank is
      currently working with the borrower to liquidate the collateral and
      pay-down the loan.  There have been expressions of interest from
      potential buyers for this property.


·
            One
      loan with an outstanding balance of approximately $4.4
      million.  As previously discussed, the borrower is currently
      seeking alternative financing to pay-down their outstanding obligation to
      the Bank.  However, the Bank is proceeding with the foreclosure
      process.





Agriculture





Balances
within this category can be attributed in large part to one
borrower.  The Bank is currently working with this borrower to
liquidate the collateral.  The Bank appraised the collateral regarding
this specific loan at an earlier date to assess the appropriate carrying value.
However, as a precautionary step we have increased our reserve in excess of the
appraisal to reflect the uncertainty surrounding liquidation of the collateral.
During the first quarter the Bank received approximately $150 thousand in
payments which were applied to principal.





At March
31, 2010, substantially all non-accruing balances were carried at their current
fair values.





Other
Real Estate Owned (“OREO”)





The
following table provides a summary for the year to date change in the balance of
OREO as of March 31, 2010:





For the three months ended(dollars in thousands)
                          
                          March 31, 2010Balance
      December 31, 2009
                          
                          $
                          946Additions
                          
                          
                          -Dispositions
                          
                          
                          -Additional
      write-downs
                          
                          
                          (205
                          )Balance
      March 31, 2010
                          
                          $
                          741





At March
31, 2010, OREO balances stood at approximately $0.7 million, approximately $0.2
million lower than that reported at December 31, 2009.  There were no
new additions to OREO during the first quarter of 2010, however the Bank did
write down the value of two properties by approximately $0.2 million based on
updated appraisal information.  The balance of OREO at March 31, 2010
can be attributed to two properties in the Bank’s primary market.  The
Bank has accepted an offer on one property and is expecting escrow to close
during the second quarter of 2010.





Total
Cash and Cash Equivalents





Total
cash and cash equivalents were $120.3 million and $40.7 million at March 31,
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.  For
additional information related to the Company’s March 2010 private placement,
please see Note 10. 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 bank lends on a short-term basis to other banks),
investments in securities and short-term interest bearing deposits at other
financial institutions.  These assets are maintained for liquidity
needs of the Bank, collateralization of public deposits, and diversification of
the earning asset mix.







Heritage
Oaks Bancorp | - 59 -


Management’s
Discussion and Analysis




The table
below summarizes the year to date change in the balances of other earning assets
as of March 31, 2010:





March 31,
                    
                    
                    December 31,
                    
                    
                    Variance(dollars in thousands)
                    
                    2010
                    
                    
                    2009
                    
                    
                    dollar
                    
                    
                    percentageInterest
      bearing due from Federal Reserve
                    
                    $
                    97,898
                    
                    
                    $
                    17,046
                    
                    
                    $
                    80,852
                    
                    
                    
                    474.32
                    %Federal
      funds sold
                    
                    
                    1,430
                    
                    
                    
                    4,350
                    
                    
                    
                    (2,920
                    )
                    
                    
                    -67.13
                    %Interest
      bearing deposits other financial institutions
                    
                    
                    119
                    
                    
                    
                    119
                    
                    
                    
                    -
                    
                    
                    
                    0.00
                    %Securities
      available for sale
                    
                    
                    128,388
                    
                    
                    
                    121,180
                    
                    
                    
                    7,208
                    
                    
                    
                    5.95
                    %Federal
      Home Loan Bank stock
                    
                    
                    5,828
                    
                    
                    
                    5,828
                    
                    
                    
                    -
                    
                    
                    
                    0.00
                    %Total
      other earning assets
                    
                    $
                    233,663
                    
                    
                    $
                    148,523
                    
                    
                    $
                    85,140
                    
                    
                    
                    57.32
                    %





Federal
Funds Sold and Interest Bearing Due from Federal Reserve





As of
March 31, 2010, the total of federal funds sold and interest bearing due from
balances was approximately $99.3 million or $77.9 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 Bank’s depositors,
the quarter to date increase, as previously mentioned, is mainly attributable to
funds received upon completion of the Company’s March 2010 private placement in
which the Company raised gross proceeds of approximately $56.0 million,
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 Bank has an Asset/Liability Committee that develops
current investment policies based upon its operating needs and market
circumstance.  The Bank’s investment policy is formally reviewed and
approved annually by the Board of Directors.  The Asset/Liability
Committee of the Bank is responsible for reporting and monitoring compliance
with the investment policy.  Reports are provided to the Bank’s Board
of Directors on a regular basis.





At March
31, 2010, the balance of the investment portfolio was approximately $128.4
million or $7.2 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 Bank made during the first three months of the year
in the aggregate amount $10.5 million and principal pay downs on mortgage
related securities totaling approximately $4.1 million.





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 March 31, 2010 the securities portfolio had net
unrealized losses, net of taxes of approximately $0.5 million, a decrease of
approximately $0.6 million from that reported at December 31,
2009.  Unrealized losses in 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.





During
2008 and 2009, the credit markets came under significant duress as investor and
consumer confidence in the U.S. financial system became significantly
destabilized.  As a result, many financial institutions in severe need
of liquidity were forced to de-leverage for a variety of reasons, selling
significant portions of their investment holdings which in turn placed
considerable pressure on the values of many classes of investment
securities.  In particular, mortgage related securities came under
substantial pressure and the Bank’s portfolio was not immune to
this.  Although substantially all of the Bank’s mortgage related
securities are considered “investment grade,” overall lack of confidence in the
housing market, the inability of many consumers to meet their mortgage related
obligations, and the strong need for liquidity during 2008 and 2009 have, among
other things, been influential in placing pressure on the prices of these types
of securities.





At March
31, 2010, the Bank owned eleven Whole Loan Private Label Mortgage Backed
Securities (“PMBS”) with a remaining principal balance of approximately $19.5
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 Bank owns with the exception of one mezzanine bond
(subordinate).  At March 31, 2010, six bonds in the approximate amount
of $11.1 million remained below investment grade.  All six of these
bonds are in senior or super senior tranche positions of their respective deals,
meaning the Bank has priority in cash flows and has subordinate tranches below
its position providing credit support.







Heritage
Oaks Bancorp | - 60 -


Management’s
Discussion and Analysis




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 this
analysis, the Company determined four securities with an aggregate remaining
book balance of approximately $5.2 million as of March 31, 2010 to be other than
temporarily impaired.  As a result, the Bank realized approximately
$372 thousand in aggregate pre-tax losses related to these securities during the
fourth quarter of 2009. In the first quarter of 2010, the Company engaged an
independent third party to review these same securities for additional
OTTI.  The results of that analysis indicated there was no additional
OTTI on these securities.  The Company will continue to engage an
independent third party to review these securities on a quarterly basis for the
foreseeable future.





The Bank
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 March 31, 2010, Management does not believe that
losses on PMBS in the portfolio, other than those previously discussed, are
other than temporary.





All PMBS
the Bank owns are in senior or super senior tranche positions of their
respective deals, except for one mezzanine bond, meaning that the Bank 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 Bank owns has increased from
the time of purchase through March 31, 2010, except for one bond.  As
the Bank 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 Bank’s mortgage securities were issued by: The Government
National Mortgage Association (“Ginnie Mae”), The Federal National Mortgage
Association (“Fannie Mae”), and The Federal Home Loan Mortgage Corporation
(“Freddie Mac”).  These securities carry the guarantee of the issuing
agencies.  At March 31, 2010 approximately $85.7 million or 81.4% of
the Bank’s mortgage related securities were issued by a government agency such
as those listed above.





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





Federal
Home Loan Bank (“FHLB”) Stock





As a
member of the Federal Home Loan Bank of San Francisco, the Bank is required to
hold a specified amount of FHLB capital stock based on the level of borrowings
the Bank has obtained from the FHLB.  As such, the amount of FHLB
stock the Bank carries can vary from one period to another based on among other
things the current liquidity needs of the Bank.  At March 31, 2010 and
December 31, 2009, the Bank held approximately $5.8 million in FHLB
stock.







Heritage
Oaks Bancorp | - 61 -


Management’s
Discussion and Analysis




Deposits
and Borrowed Funds





The
following table provides a summary for the year to date change in various
categories of deposit balances as of March 31, 2010:





Variance Exclusive ofMarch 31,
                      
                      
                      December 31,
                      
                      
                      Variance
                      
                      
                      Volatile Balances(dollars in thousands)
                      
                      2010
                      
                      
                      2009
                      
                      
                      dollar
                      
                      
                      percentage
                      
                      
                      dollar
                      
                      
                      percentageNon
      interest bearing demand
                      
                      $
                      178,976
                      
                      
                      $
                      174,635
                      
                      
                      $
                      4,341
                      
                      
                      
                      2.49
                      %
                      
                      $
                      (7,949
                      )
                      
                      
                      -4.55
                      %Interest
      bearing demand
                      
                      
                      79,585
                      
                      
                      
                      77,765
                      
                      
                      
                      1,820
                      
                      
                      
                      2.34
                      %
                      
                      
                      1,304
                      
                      
                      
                      1.68
                      %Regular
      savings
                      
                      
                      28,373
                      
                      
                      
                      27,166
                      
                      
                      
                      1,207
                      
                      
                      
                      4.44
                      %
                      
                      
                      1,207
                      
                      
                      
                      4.44
                      %Money
      market funds
                      
                      
                      269,768
                      
                      
                      
                      259,671
                      
                      
                      
                      10,097
                      
                      
                      
                      3.89
                      %
                      
                      
                      (2,478
                      )
                      
                      
                      -0.95
                      %Time
      deposits
                      
                      
                      236,169
                      
                      
                      
                      224,998
                      
                      
                      
                      11,171
                      
                      
                      
                      4.96
                      %
                      
                      
                      11,171
                      
                      
                      
                      4.96
                      %Total
      retail deposits
                      
                      
                      792,871
                      
                      
                      
                      764,235
                      
                      
                      
                      28,636
                      
                      
                      
                      3.75
                      %
                      
                      
                      3,255
                      
                      
                      
                      0.43
                      %Brokered
      time deposits
                      
                      
                      1,545
                      
                      
                      
                      10,230
                      
                      
                      
                      (8,685
                      )
                      
                      
                      -84.90
                      %
                      
                      
                      (8,685
                      )
                      
                      
                      -84.90
                      %Brokered
      money market funds
                      
                      
                      1,000
                      
                      
                      
                      1,000
                      
                      
                      
                      -
                      
                      
                      
                      0.00
                      %
                      
                      
                      -
                      
                      
                      
                      0.00
                      %Total
      brokered deposits
                      
                      
                      2,545
                      
                      
                      
                      11,230
                      
                      
                      
                      (8,685
                      )
                      
                      
                      -77.34
                      %
                      
                      
                      (8,685
                      )
                      
                      
                      -77.34
                      %Total
      deposits
                      
                      $
                      795,416
                      
                      
                      $
                      775,465
                      
                      
                      $
                      19,951
                      
                      
                      
                      2.57
                      %
                      
                      $
                      (5,430
                      )
                      
                      
                      -0.70
                      %





Deposits





As
indicated in the table above total deposit balances at March 31, 2010 were
approximately $795.4 million.  This represents an increase of
approximately $19.9 million when compared to the $775.5 million reported at
December 31, 2009.  Higher core deposit balances during 2009 allowed
the Bank to rely less on wholesale funding and brokered deposits.  At
March 31, 2010 brokered deposits totaled $2.5 million, representing a decline of
approximately $8.7 million from that reported at December 31, 2009.





During
the first three months of 2010, the Bank saw core deposit balances (non interest
and interest bearing demand, savings, money market and time certificate accounts
with balances less than $100 thousand) increase approximately $25.0 million from
that reported at December 31, 2009.





Volatile
Deposits





The Bank
monitors the balance of various accounts that it considers to be volatile for a
variety of reasons and provides this data to the Board of Directors on a regular
basis.  Accounts may be added to or removed from the volatile
liability dependency report when, based on Management’s judgment, it is
determined that these funds are not suitable for any form of long term
investment or that the risk associated with these funds leaving the Bank has
become minimal.  Typically a material change in the balances of these
accounts is reflected in the balance of federal funds sold and/or interest
bearing due from Federal Reserve.  At March 31, 2010, the aggregate
balance of deposits the Bank considers to be volatile was approximately $57.0
million or $25.4 million higher than that reported at December 31, 2009. The
Bank considers these accounts to be core relationships that experience
volatility.





The
following table provides a summary of the deposit balances the Bank considers to
be volatile as of March 31, 2010 and December 31, 2009:





Percent of
                    
                    
                    
                    
                    
                    Percent ofMarch 31,
                    
                    
                    Total
                    
                    
                    December 31,
                    
                    
                    Total
                    
                    
                    Dollar(dollars in thousands)
                    
                    2010
                    
                    
                    Deposits
                    
                    
                    2009
                    
                    
                    Deposits
                    
                    
                    VarianceNon
      interest bearing demand
                    
                    $
                    30,265
                    
                    
                    
                    3.8
                    %
                    
                    $
                    17,975
                    
                    
                    
                    2.3
                    %
                    
                    $
                    12,290Interest
      bearing demand
                    
                    
                    3,094
                    
                    
                    
                    0.4
                    %
                    
                    
                    2,578
                    
                    
                    
                    0.3
                    %
                    
                    
                    516Money
      market funds
                    
                    
                    23,688
                    
                    
                    
                    3.0
                    %
                    
                    
                    11,113
                    
                    
                    
                    1.4
                    %
                    
                    
                    12,575Total
      volatile deposits
                    
                    $
                    57,047
                    
                    
                    
                    7.2
                    %
                    
                    $
                    31,666
                    
                    
                    
                    4.0
                    %
                    
                    $
                    25,381





The year
to date increase in balances the Bank considers to be volatile can be attributed
in large part to increases in volatile non-interest bearing demand and money
market funds balances of approximately $24.9 million.  The customers
that hold the non-interest bearing deposits engage in mortgage related
activities.  As more and more home owners have moved to re-finance
existing mortgages, given the current rate environment, deposit balances related
to these customers have increased.  Management and the Board of
Directors are aware that as conditions in the market change these relationships
will be impacted.







Heritage
Oaks Bancorp | - 62 -


Management’s
Discussion and Analysis




Borrowed
Funds





The Bank
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.





At March
31, 2010, borrowings obtained from the FHLB comprised the majority of borrowed
funds.  The following table provides a summary of FHLB borrowings the
Bank had outstanding as of March 31, 2010:





(dollars
      in thousands)Amount
                                            
                                            Interest
                                            
                                            
                                            MaturityBorrowed
                                            
                                            Rate
                                            
                                            
                                            Variable/Fixed
                                            
                                            
                                            Date$
                                            10,000
                                            
                                            
                                            2.89
                                            %
                                            
                                            Fixed
                                            
                                            
                                            9/16/201035,000
                                            
                                            
                                            0.13
                                            %
                                            
                                            Adjustable
                                            
                                            
                                            1/31/201120,000
                                            
                                            
                                            0.24
                                            %
                                            
                                            Variable
                                            
                                            
                                            Open$
                                            65,000
                                            
                                            
                                            0.59
                                            %





As
evidenced in the table above, the balance of FHLB borrowing as of March 31, 2010
was $65.0 million and unchanged from the balance reported at December 31,
2009.





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





Capital





At March
31, 2010, the balance of stockholders’ equity was approximately $135.2
million.  This, when compared to the $83.8 million at December 31,
2009, represents an increase of approximately $51.4 million.  The year
to date change in capital is due primarily to the issuance of Series B and
Series C Preferred Stock in the Company’s March 2010 private placement.
Additionally, the year to date change is also attributed to net losses of $1.3
million, the impact of year-to-date share-based compensation expense in the
amount of $0.1 million, dividends paid on Series A Senior Preferred stock in the
amount of $0.3 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 $0.6 million.





Series
B and Series C Preferred Stock





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, pending
receipt of regulatory approvals required for the particular investor purchasing
such shares.


In
connection with the March 2010 private placement the Company is seeking certain
shareholder approvals at its upcoming annual meeting. Specifically, the Company
is seeking shareholder approval to increase its authorized common stock to 100
million shares, and the conversion of the Series B and C Series Preferred stock
to common stock. If the shareholder approvals are received before September 12,
2010, no dividends will be owed on the Series B Preferred Stock. If shareholder
approval is not received by that date, dividends will be owed on the Series B
Preferred Stock from the date of issuance, March 12, and the conversion price of
the Series B Preferred Stock will be reduced by 10%.


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




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







Heritage
Oaks Bancorp | - 63 -


Management’s
Discussion and Analysis




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





Dividends





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





DividendAmount
                      
                      
                      Declaration
                      
                      
                      Record
                      
                      
                      PayableDividend Type
                      
                      Per Share
                      
                      
                      Date
                      
                      
                      Date
                      
                      
                      DateStock
      dividend
                      
                      
                      5
                      %
                      
                      
                      04/24/08
                      
                      
                      
                      05/02/08
                      
                      
                      
                      05/16/08Cash
      dividend
                      
                      $
                      0.08
                      
                      
                      01/24/08
                      
                      
                      02/01/08
                      
                      
                      02/15/08




As
evidenced in the table above, on April 24, 2008, the Board of Directors declared
a stock dividend in the amount of 5% which was paid on May 16, 2008 to
shareholders of record on May 2, 2008.  Shares and earnings per share
for all prior periods have been adjusted to fully reflect the impact of the May
2008 stock dividend.  The Company paid no dividends on its common
stock during the first three months of 2010 and as part of its participation in
the U.S. Treasury’s CPP, must seek the approval of the Treasury before doing so.
In
addition, the Written Agreement, as more fully discussed in Note 12 of the
consolidated financial statements filed on this Form 10-Q, requires the Company
to seek prior approval from the Federal Reserve for any payment of dividends on
its common or preferred stock.





Trust
Preferred Securities





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





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





At March
31, 2010, the Company had at total of $13.4 million in Junior Subordinated
Deferrable Interest Debentures issued and outstanding.  As mentioned
in the preceding paragraphs, these securities have been issued to Trusts II and
III.  The debt securities are subordinated to effectively all
borrowings of the Company and can be redeemed at par if certain events occur
that impact the tax treatment, regulatory treatment or the capital treatment of
the issuance.  Upon the issuance of the debt securities, the Company
purchased a 3.1% minority interest in both Trusts II and III, totaling $248
thousand and $155 thousand, respectively.  The balance of the equity
of Trusts II and III is comprised of mandatory redeemable preferred securities
and is included in other assets.  Interest associated with the
securities issued to both Trusts II and III is payable quarterly at 3-month
LIBOR plus 1.72% variable rate and 6.888% fixed, respectively.





The
following table provides a summary of the securities the Company has issued to
Trusts II and III as of March 31, 2010:





Amount
                                    
                                    
                                    Current
                                    
                                    
                                    Issue
                                    
                                    
                                    Scheduled
                                    
                                    
                                    Call(dollars in thousands)
                                    
                                    Issued
                                    
                                    
                                    Rate
                                    
                                    
                                    Date
                                    
                                    
                                    Maturity
                                    
                                    
                                    Date
                                    
                                    
                                    Rate TypeHeritage
      Oaks Capital Trust II
                                    
                                    $
                                    8,248
                                    
                                    
                                    
                                    1.97
                                    %
                                    
                                    27-Oct-06
                                    
                                    
                                    Aug-37
                                    
                                    
                                    Nov-11
                                    
                                    
                                    Variable
      3-month LIBOR + 1.72%Heritage
      Oaks Capital Trust III
                                    
                                    
                                    5,155
                                    
                                    
                                    
                                    6.89
                                    %
                                    
                                    20-Sep-07
                                    
                                    
                                    Sep-37
                                    
                                    
                                    Dec-12
                                    
                                    
                                    5-year
      Fixed SWAP + 2.00%Total
      Issued
                                    
                                    $
                                    13,403
                                    
                                    
                                    
                                    3.86
                                    %




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







Heritage
Oaks Bancorp | - 64 -


Management’s
Discussion and Analysis




Pursuant
to U.S. GAAP, the Company is not allowed to consolidate Trusts II and III 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 March 31, 2010,
the Company included $13.0 million of the net junior subordinated debt in its
Tier I Capital for regulatory capital purposes.





At March
31, 2010, the Company had sufficient cash to service the $13.4 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 4 years without dividends from subsidiaries. In
addition, the Written Agreement, as more fully discussed in Note 12 of the
consolidated financial statements filed on this Form 10-Q, requires the Company
to seek prior approval from the Federal Reserve for any payment of interest or
principal on its trust preferred securities.





Regulatory
Capital Requirements





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





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





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 11. 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 March 31, 2010 and 2009:





Regulatory Standard
                
                
                March 31, 2010
                
                
                March 31, 2009Adequately
                
                
                Well
                
                
                Heritage Oaks
                
                
                Heritage OaksRatio
                
                Capitalized
                
                
                Capitalized
                
                
                Bancorp
                
                
                Bank
                
                
                Bancorp
                
                
                BankLeverage
      ratio
                
                
                4.00
                %
                
                
                5.00
                %
                
                
                7.71
                %
                
                
                12.61
                %
                
                
                11.35
                %
                
                
                9.75
                %Tier
      I capital to risk weighted assets
                
                
                4.00
                %
                
                
                6.00
                %
                
                
                9.24
                %
                
                
                15.07
                %
                
                
                11.92
                %
                
                
                10.24
                %Total
      risk based capital to risk weighted assets
                
                
                8.00
                %
                
                
                10.00
                %
                
                
                17.16
                %
                
                
                16.34
                %
                
                
                13.17
                %
                
                
                11.49
                %





Regulatory
capital ratios as of March 31, 2010 fully reflect the issuance of $56.0 million
in gross proceeds of Series B and Series C Preferred Stock issued through a
private placement.  The preferred stock issued in the Company’s March
2010 private placement qualifies as Tier II capital.  The Company
subsequently down-streamed $48.0 million of those proceeds 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.





Liquidity





The
objective of liquidity management is to ensure the continuous availability of
funds to meet the demands of depositors, investors and
borrowers.  Asset liquidity is primarily derived from loan payments
and the maturity of other earning assets.  Liquidity from liabilities
is obtained primarily from the receipt of new deposits.  The Bank’s
Asset Liability Committee (“ALCO”) is responsible for managing the on and
off-balance sheet commitments to meet the needs of customers while achieving the
Bank’s financial objectives.  ALCO meets regularly to assess the
projected funding requirements by reviewing historical funding patterns, current
and forecasted economic conditions and individual customer funding
needs.  Deposits generated from the Bank’s customers serve as the
primary source of liquidity.  The Bank has credit arrangements with
correspondent banks that serve as a secondary liquidity source.  At
March 31, 2010, these credit lines totaled $15.0 million and the Bank had no
borrowings against those lines.  As previously mentioned the Bank is a
member of the FHLB and has collateralized borrowing capacities remaining of
$70.4 million at March 31, 2010.  Additionally, the Bank has
established and tested a borrowing facility with the Federal
Reserve.  The amount of available credit is determined by the
collateral provided by the Bank at the time of a transaction.







Heritage
Oaks Bancorp | - 65 -


Management’s
Discussion and Analysis




The Bank
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 March
31, 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 30.94% at March 31, 2010
compared to 20.50% at December 31, 2009.  At March 31, 2010, the Bank
was within its internal guideline for liquidity.  As of March 31, 2010
the fair market value of the Bank’s investment portfolio was approximately
$128.4 million, of which approximately $7.5 million was pledged to secure public
deposits and other purposes.  The ratio of gross loans to deposits
(“LTD”), another key liquidity ratio, was 90.9% at March 31, 2010 compared to
94.0% at December 31, 2009 both of which are and were within the Bank’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 Bank 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 $13.4 million in debt securities discussed under “Capital,” the Company issued
the full and unconditional payment guarantee of certain accrued
distributions.







Heritage
Oaks Bancorp | - 66 -


Item
3.  Quantitative and Qualitative Disclosure About Market
Risk





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




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




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





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




The
hypothetical impacts of sudden interest rate movements applied to the Company’s
asset and liability balances are modeled monthly. The results of these models
indicate how much of the Company’s net interest income is “at risk” from various
rate changes over a one year horizon. This exercise is valuable in identifying
risk exposures. Management believes the results for the Company’s March 31, 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 March 31, 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
                  
                  $
                  44,089
                  
                  
                  $
                  45,020
                  
                  
                  $
                  45,533
                  
                  
                  $
                  45,946
                  
                  
                  $
                  46,564Dollar
      change from base
                  
                  $
                  (1,444
                  )
                  
                  $
                  (513
                  )
                  
                  $
                  -
                  
                  
                  $
                  413
                  
                  
                  $
                  1,031Percentage
      change from base
                  
                  
                  -3.17
                  %
                  
                  
                  -1.13
                  %
                  
                  
                  0.00
                  %
                  
                  
                  0.91
                  %
                  
                  
                  2.27
                  %




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 | - 67 -


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 March 31,
2010:





(dollars in thousands)Percent ofRate Type
                      
                      Balance
                      
                      
                      TotalVariable
      daily
                      
                      $
                      270,522
                      
                      
                      
                      37.4
                      %Variable
      other than daily
                      
                      
                      314,399
                      
                      
                      
                      43.5
                      %Fixed
                      
                      
                      137,822
                      
                      
                      
                      19.1
                      %Total
      gross loans
                      
                      $
                      722,743
                      
                      
                      
                      100.0
                      %





The table
above identifies approximately 37.4% of the loan portfolio that will re-price
immediately in a changing rate environment.  At March 31, 2010,
approximately $584.9 million or 80.9% of the Bank’s loan portfolio is considered
variable.





(dollars in thousands)Percent ofRe-Pricing
                      
                      Balance
                      
                      
                      Total<
      1 Year
                      
                      $
                      425,583
                      
                      
                      
                      58.9
                      %1-3
      Years
                      
                      
                      162,172
                      
                      
                      
                      22.4
                      %3-5
      Years
                      
                      
                      85,773
                      
                      
                      
                      11.9
                      %>
      5 Years
                      
                      
                      49,215
                      
                      
                      
                      6.8
                      %Total
      gross loans
                      
                      $
                      722,743
                      
                      
                      
                      100.0
                      %





The
following table provides a summary of the loans the Bank can expect to see come
off their floors if the Prime rate were to increase by the amounts identified
below as of March 31, 2010:





Move in Prime Rate (bps)(dollars in thousands)
                              
                              +200
                              
                              
                              +250
                              
                              
                              +300
                              
                              
                              +350Variable
      daily
                              
                              $
                              816
                              
                              
                              $
                              18,413
                              
                              
                              $
                              71,555
                              
                              
                              $
                              139,100Variable
      other than daily
                              
                              
                              2,314
                              
                              
                              
                              4,852
                              
                              
                              
                              52,556
                              
                              
                              
                              154,449Cumulative
      total variable at floor
                              
                              $
                              3,130
                              
                              
                              $
                              23,265
                              
                              
                              $
                              124,111
                              
                              
                              $
                              293,549




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 Bank will need to see rates increase
significantly before the majority of loans in the portfolio start to come off
their floors.





Item
4.  Controls and Procedures





Evaluation
of Disclosure Controls and Procedures





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





Changes
in Internal Control Over Financial Reporting





There was
no change in the Company’s internal controls over financial reporting during the
quarter ended March 31, 2010 that has materially affected, or is reasonably
likely to materially affect, the Company’s internal controls over financial
reporting.







Heritage
Oaks Bancorp | - 68 -


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





Part
II.  Other Information





Item
1.  Legal Proceedings





The 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,
is named in two causes of action alleging (1) negligence and (2) aiding and
abetting Hurst Financial's allegedly illegal lending practices. 
The Bank did not lend to any of the plaintiffs or to Hurst Financial, nor
did the Bank have any contact whatsoever with the plaintiffs in relation to
their transactions with Hurst Financial.  The Bank has foreclosed upon
and now owns one of the properties Hurst Financial purportedly financed for the
developer using funds raised from the plaintiffs.  The 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 anticipates a favorable outcome to the case and does not expect the
litigation to have any significant financial impact to the Bank.





Except as
indicated above, neither the Company nor the Bank 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 March 31, 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





Information
required by this item is incorporated here by reference to the Company’s 8-K
filings with the SEC on March 10, 2010 and March 12, 2010, both Commission File
Number 000-25020.





Purchases
of Equity Securities





None.





Item
3.  Defaults upon Senior Securities





None.





Item
4.  (Removed and Reserved)





None.







Heritage
Oaks Bancorp | - 69 -


Item
5.  Other Information





Not
applicable.





Item
6.  Exhibits





(a)
Exhibits:





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







Heritage
Oaks Bancorp | - 70 -


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:
May
5, 2010





/s/ Lawrence P. WardLawrence
      P. WardPresidentChief
      Executive Officer
                    (Principal Executive Officer)/s/ Margaret A. TorresMargaret
      A. TorresExecutive
      Vice PresidentChief
      Financial Officer(Principal
      Financial and Accounting Officer)







Heritage
Oaks Bancorp | - 71 -