UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549


FORM
10-Q








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


For
      the quarterly period ended September 30,
2009.





or





o
            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 x     Non-accelerated
filer  ̈    Smaller
reporting company  ̈





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





YES  ̈      NO
x





Indicate
the number of shares outstanding of each of the issuer's classes of common
stock, as of the latest practicable date:  As of November 2, 2009
there were 7,759,718 shares outstanding of the Registrant’s common
stock.










PagePart
      I.  Financial Information
                                                                                                                                                  3Item
      1.  Consolidated Financial Statements (un-audited, except for
      Balance Sheet as of 12/31/2008)
                                                                                                                                                  3Consolidated
      Balance Sheets
                                                                                                                                                  4Consolidated
      Statements of Income
                                                                                                                                                  5Consolidated
      Statements of Stockholders' Equity
                                                                                                                                                  6Consolidated
      Statements of Comprehensive Income
                                                                                                                                                  7Consolidated
      Statements of Cash Flows
                                                                                                                                                  8Notes
      to Consolidated Financial Statements
                                                                                                                                                  9Note
      1.  Consolidated Financial Statements
                                                                                                                                                  9Note
      2.  Investment Securities
                                                                                                                                                  9Note
      3.  Loans and the Allowance for Loan Losses
                                                                                                                                                  11Note
      4.  Earnings Per Share
                                                                                                                                                  12Note
      5.  Recent Accounting Pronouncements
                                                                                                                                                  13Note
      6.  Share-Based Compensation
                                                                                                                                                  16Note
      7.  Fair Value Disclosures
                                                                                                                                                  18Note
      8.  Fair Value of Financial Instruments
                                                                                                                                                  20Note
      9.  Preferred Stock
                                                                                                                                                  22Note
      10.  Subsequent Events
                                                                                                                                                  23Note
      11.  Reclassifications
                                                                                                                                                  23Forward
      Looking Statements
                                                                                                                                                  24Item
      2.  Management's Discussion and Analysis of Financial Condition
      and Results of Operations
                                                                                                                                                  25The
      Company
                                                                                                                                                  25Where
      You Can Find More Information
                                                                                                                                                  25Executive
      Summary
                                                                                                                                                  26Recent
      Developments
                                                                                                                                                  28Dividends
      and Stock Repurchases
                                                                                                                                                  29Selected
      Financial Data
                                                                                                                                                  29Local
      Economy
                                                                                                                                                  30Critical
      Accounting Policies
                                                                                                                                                  30Results
      of Operations
                                                                                                                                                  32Net
      Interest Income and Margin
                                                                                                                                                  33Non-Interest
      Income
                                                                                                                                                  38Non-Interest
      Expenses
                                                                                                                                                  40Provision
      for Income Taxes
                                                                                                                                                  41Provision
      for Loan Losses
                                                                                                                                                  42Financial
      Condition
                                                                                                                                                  44Loans
                                                                                                                                                  44Allowance
      for Loan Losses
                                                                                                                                                  49Non-Performing
      Assets
                                                                                                                                                  50Total
      Cash and Cash Equivalents
                                                                                                                                                  54Investment
      Securities and Other Earning Assets
                                                                                                                                                  54Deposits
      and Borrowed Funds
                                                                                                                                                  56Capital
                                                                                                                                                  57Liquidity
                                                                                                                                                  60Inflation
                                                                                                                                                  61Off-Balance
      Sheet Arrangements
                                                                                                                                                  61Item
      3.  Quantative and Qualitative Disclosure About Market
      Risk
                                                                                                                                                  62Item
      4.  Controls and Procedures
                                                                                                                                                  63Part
      II.  Other Information
                                                                                                                                                  64Item
      1.  Legal Proceedings
                                                                                                                                                  64Item
      1A.  Risk Factors
                                                                                                                                                  64Item
      2.  Unregistered Sales of Equity Securities and Use of
      Proceeds
                                                                                                                                                  68Item
      3.  Defaults upon Senior Securities
                                                                                                                                                  68Item
      4.  Submission of Matters to a Vote of Security
      Holders
                                                                                                                                                  68Item
      5.  Other Information
                                                                                                                                                  68Item
      6.  Exhibits
                                                                                                                                                  68Signatures
                                                                                                                                                  69
 
 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)September
      30,
                                                
                                                
                                                December
      31,(dollars in thousands except per share
      data)
                                                
                                                2009
                                                
                                                
                                                2008AssetsCash
      and due from banks
                                                
                                                $
                                                18,155
                                                
                                                
                                                $
                                                17,921Federal funds sold
                                                
                                                
                                                45,740
                                                
                                                
                                                
                                                6,650Total
      cash and cash equivalents
                                                
                                                
                                                63,895
                                                
                                                
                                                
                                                24,571Interest
      bearing deposits with other banks
                                                
                                                
                                                119
                                                
                                                
                                                
                                                119Securities
      available for sale
                                                
                                                
                                                102,871
                                                
                                                
                                                
                                                50,762Federal
      Home Loan Bank stock, at cost
                                                
                                                
                                                5,828
                                                
                                                
                                                
                                                5,123Loans
      held for sale
                                                
                                                
                                                7,778
                                                
                                                
                                                
                                                7,939Loans,
      net of deferred fees of $1,635 and $1,701 and allowance for loan loss of
      $15,873 and $10,412 at September 30, 2009 and
                                                
                                                
                                                692,359
                                                
                                                
                                                
                                                668,034December
      31, 2008, respectively.Property,
      premises and equipment, net
                                                
                                                
                                                6,984
                                                
                                                
                                                
                                                6,827Deferred
      tax assets
                                                
                                                
                                                12,379
                                                
                                                
                                                
                                                7,708Bank
      owned life insurance
                                                
                                                
                                                11,432
                                                
                                                
                                                
                                                10,737Goodwill
                                                
                                                
                                                11,049
                                                
                                                
                                                
                                                11,049Core
      deposit intangible
                                                
                                                
                                                2,904
                                                
                                                
                                                
                                                3,691Other
      real estate owned
                                                
                                                
                                                2,607
                                                
                                                
                                                
                                                1,337Other assets
                                                
                                                
                                                6,600
                                                
                                                
                                                
                                                7,691Total assets
                                                
                                                $
                                                926,805
                                                
                                                
                                                $
                                                805,588LiabilitiesDepositsDemand,
      non-interest bearing
                                                
                                                $
                                                181,670
                                                
                                                
                                                $
                                                147,044Savings,
      NOW, and money market deposits
                                                
                                                
                                                329,186
                                                
                                                
                                                
                                                296,488Time
      deposits of $100 or more
                                                
                                                
                                                125,230
                                                
                                                
                                                
                                                75,111Time deposits under $100
                                                
                                                
                                                117,443
                                                
                                                
                                                
                                                84,878Total
      deposits
                                                
                                                
                                                753,529
                                                
                                                
                                                
                                                603,521Short
      term FHLB borrowing
                                                
                                                
                                                65,000
                                                
                                                
                                                
                                                99,000Long
      term FHLB borrowing
                                                
                                                
                                                -
                                                
                                                
                                                
                                                10,000Securities
      sold under agreement to repurchase
                                                
                                                
                                                -
                                                
                                                
                                                
                                                2,796Junior
      subordinated debentures
                                                
                                                
                                                13,403
                                                
                                                
                                                
                                                13,403Other liabilities
                                                
                                                
                                                7,087
                                                
                                                
                                                
                                                6,836Total liabilities
                                                
                                                
                                                839,019
                                                
                                                
                                                
                                                735,556Commitments
      and contingencies
                                                
                                                
                                                -
                                                
                                                
                                                
                                                -Stockholders'
      EquitySenior
      preferred stock, no par value; $1,000 per share stated value 5,000,000
      shares authorized, 21,000 and 0 issued and outstanding as of September 30,
      2009 and December 31, 2008, respectively.
                                                
                                                
                                                19,341
                                                
                                                
                                                
                                                -Common
      stock, no par value; 20,000,000 shares authorized, issued and outstanding
      7,760,505 and 7,753,078 as of September 30, 2009 and December 31, 2008,
      respectively.
                                                
                                                
                                                48,695
                                                
                                                
                                                
                                                48,649Additional
      paid in capital
                                                
                                                
                                                3,172
                                                
                                                
                                                
                                                1,055Retained
      earnings
                                                
                                                
                                                17,174
                                                
                                                
                                                
                                                21,420Accumulated
      other comprehensive loss, net of tax benefit of $417 and $763 as of September 30, 2009 and December 31, 2008,
      respectively.
                                                
                                                
                                                (596
                                                )
                                                
                                                
                                                (1,092
                                                )Total stockholders' equity
                                                
                                                
                                                87,786
                                                
                                                
                                                
                                                70,032Total liabilities and stockholders'
      equity
                                                
                                                $
                                                926,805
                                                
                                                
                                                $
                                                805,588
 
 See notes
to condensed consolidated financial statements.
 
 Heritage
Oaks Bancorp | - 4 -
  
 
 Heritage
Oaks Bancorp
 and
Subsidiaries
 Consolidated
Statements of Income
 
 For
      the three months
                                                        
                                                        
                                                        For
      the nine monthsended September 30,
                                                        
                                                        
                                                        ended September 30,(dollars in thousands except per share
      data)
                                                        
                                                        2009
                                                        
                                                        
                                                        2008
                                                        
                                                        
                                                        2009
                                                        
                                                        
                                                        2008Interest
      IncomeInterest
      and fees on loans
                                                        
                                                        $
                                                        10,703
                                                        
                                                        
                                                        $
                                                        11,731
                                                        
                                                        
                                                        $
                                                        33,266
                                                        
                                                        
                                                        $
                                                        35,554Interest
      on investment securitiesMortgage
      backed securities
                                                        
                                                        
                                                        871
                                                        
                                                        
                                                        
                                                        515
                                                        
                                                        
                                                        
                                                        2,044
                                                        
                                                        
                                                        
                                                        1,481Obligations
      of state and political subdivisions
                                                        
                                                        
                                                        247
                                                        
                                                        
                                                        
                                                        186
                                                        
                                                        
                                                        
                                                        641
                                                        
                                                        
                                                        
                                                        555Interest
      on time deposits with other banks
                                                        
                                                        
                                                        1
                                                        
                                                        
                                                        
                                                        1
                                                        
                                                        
                                                        
                                                        3
                                                        
                                                        
                                                        
                                                        7Interest
      on federal funds sold
                                                        
                                                        
                                                        21
                                                        
                                                        
                                                        
                                                        18
                                                        
                                                        
                                                        
                                                        38
                                                        
                                                        
                                                        
                                                        130Interest on other
securities
                                                        
                                                        
                                                        17
                                                        
                                                        
                                                        
                                                        85
                                                        
                                                        
                                                        
                                                        33
                                                        
                                                        
                                                        
                                                        200Total interest income
                                                        
                                                        
                                                        11,860
                                                        
                                                        
                                                        
                                                        12,536
                                                        
                                                        
                                                        
                                                        36,025
                                                        
                                                        
                                                        
                                                        37,927Interest
      ExpenseInterest
      on savings, NOW and money market deposits
                                                        
                                                        
                                                        984
                                                        
                                                        
                                                        
                                                        886
                                                        
                                                        
                                                        
                                                        2,640
                                                        
                                                        
                                                        
                                                        3,412Interest
      on time deposits in denominations of $100 or more
                                                        
                                                        
                                                        695
                                                        
                                                        
                                                        
                                                        620
                                                        
                                                        
                                                        
                                                        1,870
                                                        
                                                        
                                                        
                                                        1,825Interest
      on time deposits under $100
                                                        
                                                        
                                                        675
                                                        
                                                        
                                                        
                                                        702
                                                        
                                                        
                                                        
                                                        1,903
                                                        
                                                        
                                                        
                                                        2,276Other borrowings
                                                        
                                                        
                                                        241
                                                        
                                                        
                                                        
                                                        803
                                                        
                                                        
                                                        
                                                        938
                                                        
                                                        
                                                        
                                                        2,180Total interest expense
                                                        
                                                        
                                                        2,595
                                                        
                                                        
                                                        
                                                        3,011
                                                        
                                                        
                                                        
                                                        7,351
                                                        
                                                        
                                                        
                                                        9,693Net interest income before provision for possible
      loan losses
                                                        
                                                        
                                                        9,265
                                                        
                                                        
                                                        
                                                        9,525
                                                        
                                                        
                                                        
                                                        28,674
                                                        
                                                        
                                                        
                                                        28,234Provision for possible loan
      losses
                                                        
                                                        
                                                        9,756
                                                        
                                                        
                                                        
                                                        3,200
                                                        
                                                        
                                                        
                                                        14,566
                                                        
                                                        
                                                        
                                                        6,215Net interest (loss) / income after provision for
      possible loan losses
                                                        
                                                        
                                                        (491
                                                        )
                                                        
                                                        
                                                        6,325
                                                        
                                                        
                                                        
                                                        14,108
                                                        
                                                        
                                                        
                                                        22,019Non
      Interest IncomeFees
      and service charges
                                                        
                                                        
                                                        750
                                                        
                                                        
                                                        
                                                        878
                                                        
                                                        
                                                        
                                                        2,214
                                                        
                                                        
                                                        
                                                        2,487Gain
      on sale of investment securities
                                                        
                                                        
                                                        211
                                                        
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        333
                                                        
                                                        
                                                        
                                                        37Loss
      on sale of OREO
                                                        
                                                        
                                                        (200
                                                        )
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        (331
                                                        )
                                                        
                                                        
                                                        -Gain
      on sale of SBA loans
                                                        
                                                        
                                                        70
                                                        
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        70
                                                        
                                                        
                                                        
                                                        -Other
                                                        
                                                        
                                                        762
                                                        
                                                        
                                                        
                                                        635
                                                        
                                                        
                                                        
                                                        2,467
                                                        
                                                        
                                                        
                                                        2,184Total non interest income
                                                        
                                                        
                                                        1,593
                                                        
                                                        
                                                        
                                                        1,513
                                                        
                                                        
                                                        
                                                        4,753
                                                        
                                                        
                                                        
                                                        4,708Non
      Interest ExpensesSalaries
      and employee benefits
                                                        
                                                        
                                                        3,969
                                                        
                                                        
                                                        
                                                        3,651
                                                        
                                                        
                                                        
                                                        11,517
                                                        
                                                        
                                                        
                                                        11,897Equipment
                                                        
                                                        
                                                        365
                                                        
                                                        
                                                        
                                                        335
                                                        
                                                        
                                                        
                                                        1,066
                                                        
                                                        
                                                        
                                                        1,053Occupancy
                                                        
                                                        
                                                        843
                                                        
                                                        
                                                        
                                                        741
                                                        
                                                        
                                                        
                                                        2,521
                                                        
                                                        
                                                        
                                                        2,291Other
                                                        
                                                        
                                                        5,074
                                                        
                                                        
                                                        
                                                        2,381
                                                        
                                                        
                                                        
                                                        10,586
                                                        
                                                        
                                                        
                                                        6,985Total non interest expenses
                                                        
                                                        
                                                        10,251
                                                        
                                                        
                                                        
                                                        7,108
                                                        
                                                        
                                                        
                                                        25,690
                                                        
                                                        
                                                        
                                                        22,226(Loss) / income before provision for income
      taxes
                                                        
                                                        
                                                        (9,149
                                                        )
                                                        
                                                        
                                                        730
                                                        
                                                        
                                                        
                                                        (6,829
                                                        )
                                                        
                                                        
                                                        4,501Provision for income taxes
                                                        
                                                        
                                                        (3,907
                                                        )
                                                        
                                                        
                                                        196
                                                        
                                                        
                                                        
                                                        (3,196
                                                        )
                                                        
                                                        
                                                        1,601Net (loss) / income
                                                        
                                                        
                                                        (5,242
                                                        )
                                                        
                                                        
                                                        534
                                                        
                                                        
                                                        
                                                        (3,633
                                                        )
                                                        
                                                        
                                                        2,900Dividends and accretion on preferred
      stock
                                                        
                                                        
                                                        352
                                                        
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        613
                                                        
                                                        
                                                        
                                                        -Net (loss) / income available to common
      shareholders
                                                        
                                                        $
                                                        (5,594
                                                        )
                                                        
                                                        $
                                                        534
                                                        
                                                        
                                                        $
                                                        (4,246
                                                        )
                                                        
                                                        $
                                                        2,900(Loss)
      / Earnings Per Common ShareBasic
                                                        
                                                        $
                                                        (0.73
                                                        )
                                                        
                                                        $
                                                        0.07
                                                        
                                                        
                                                        $
                                                        (0.56
                                                        )
                                                        
                                                        $
                                                        0.38Diluted
                                                        
                                                        $
                                                        (0.73
                                                        )
                                                        
                                                        $
                                                        0.07
                                                        
                                                        
                                                        $
                                                        (0.56
                                                        )
                                                        
                                                        $
                                                        0.37
 
 See notes
to condensed consolidated financial statements.
 
 Heritage
Oaks Bancorp | - 5 -
  
 
 Heritage
Oaks Bancorp
 and
Subsidiaries
 Consolidated
Statements of Stockholders' Equity
 
 AccumulatedPreferred
      Stock
                                                
                                                
                                                Common
      Stock
                                                
                                                
                                                Additional
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                Other
                                                
                                                
                                                TotalNumber
      of
                                                
                                                
                                                
                                                
                                                
                                                Number
      of
                                                
                                                
                                                
                                                
                                                
                                                Paid-In
                                                
                                                
                                                Comprehensive
                                                
                                                
                                                Retained
                                                
                                                
                                                Comprehensive
                                                
                                                
                                                Stockholders'(dollars
      in thousands)
                                                
                                                Shares
                                                
                                                
                                                Amount
                                                
                                                
                                                Shares
                                                
                                                
                                                Amount
                                                
                                                
                                                Capital
                                                
                                                
                                                Income
                                                
                                                
                                                Earnings
                                                
                                                
                                                Income
                                                
                                                
                                                EquityBalance,
      December 31, 2008
                                                
                                                
                                                -
                                                
                                                
                                                $
                                                -
                                                
                                                
                                                
                                                7,753,078
                                                
                                                
                                                $
                                                48,649
                                                
                                                
                                                $
                                                1,055
                                                
                                                
                                                
                                                
                                                
                                                $
                                                21,420
                                                
                                                
                                                $
                                                (1,092
                                                )
                                                
                                                $
                                                70,032Issuance
      of preferred stock and common stock warrant
                                                
                                                
                                                21,000
                                                
                                                
                                                
                                                19,152
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                1,848
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                21,000Amortization
      of discount on preferred stock
                                                
                                                
                                                
                                                
                                                
                                                
                                                189
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                (189
                                                )
                                                
                                                
                                                
                                                
                                                
                                                
                                                -Dividends
      paid on preferred stock
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                (424
                                                )
                                                
                                                
                                                
                                                
                                                
                                                
                                                (424
                                                )Exercise
      of stock options
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                -(including
      $9 excess tax benefit
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                -from
      exercise of stock options)
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                10,050
                                                
                                                
                                                
                                                46
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                46Share-based
      compensation expense
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                269
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                269Retirement
      of restricted share awards
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                (2,623
                                                )Comprehensive
      income:Net
      loss
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                $
                                                (3,633
                                                )
                                                
                                                
                                                (3,633
                                                )
                                                
                                                
                                                
                                                
                                                
                                                
                                                (3,633
                                                )Unrealized
      security holding gains (net of $483 tax)
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                692
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                692
                                                
                                                
                                                
                                                692Realized
      gains on sale of securities (net of $137 tax)
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                (196
                                                )
                                                
                                                
                                                
                                                
                                                
                                                
                                                (196
                                                )
                                                
                                                
                                                (196
                                                )Total
      comprehensive loss
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                $
                                                (3,137
                                                )Balance,
      September 30, 2009
                                                
                                                
                                                21,000
                                                
                                                
                                                $
                                                19,341
                                                
                                                
                                                
                                                7,760,505
                                                
                                                
                                                $
                                                48,695
                                                
                                                
                                                $
                                                3,172
                                                
                                                
                                                
                                                
                                                
                                                
                                                $
                                                17,174
                                                
                                                
                                                $
                                                (596
                                                )
                                                
                                                $
                                                87,786Balance,
      December 31, 2007
                                                
                                                
                                                -
                                                
                                                
                                                $
                                                -
                                                
                                                
                                                
                                                7,317,932
                                                
                                                
                                                $
                                                43,996
                                                
                                                
                                                $
                                                672
                                                
                                                
                                                
                                                
                                                
                                                
                                                $
                                                24,598
                                                
                                                
                                                $
                                                184
                                                
                                                
                                                $
                                                69,450Exercise
      of stock options (including $88 excess tax benefit from exercise of stock
      options)
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                31,228
                                                
                                                
                                                
                                                228
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                2285%
      Stock Dividend distributed May 16, 2008
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                366,344
                                                
                                                
                                                
                                                4,232
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                (4,232
                                                )
                                                
                                                
                                                
                                                
                                                
                                                
                                                -Cash
      paid in lieu of fractional shares
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                (5
                                                )
                                                
                                                
                                                
                                                
                                                
                                                
                                                (5
                                                )Cash
      dividends - $0.08 per share
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                (586
                                                )
                                                
                                                
                                                
                                                
                                                
                                                
                                                (586
                                                )Share-based
      compensation expense
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                275
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                275Issuance
      of restricted stock awards
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                1,000
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                -Retirement
      of restricted share awards
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                (6,904
                                                )
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                -Comprehensive
      income:Net
      income
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                $
                                                2,900
                                                
                                                
                                                
                                                2,900
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                2,900Unrealized
      security holding losses (net of $900 tax benefit)
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                (1,286
                                                )
                                                
                                                
                                                
                                                
                                                
                                                
                                                (1,286
                                                )
                                                
                                                
                                                (1,286
                                                )Realized
      gains on sale of securities (net of $15 tax)
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                (22
                                                )
                                                
                                                
                                                
                                                
                                                
                                                
                                                (22
                                                )
                                                
                                                
                                                (22
                                                )Total
      comprehensive income
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                
                                                $
                                                1,592Balance,
      September 30, 2008
                                                
                                                
                                                -
                                                
                                                
                                                $
                                                -
                                                
                                                
                                                
                                                7,709,600
                                                
                                                
                                                $
                                                48,456
                                                
                                                
                                                $
                                                947
                                                
                                                
                                                
                                                
                                                
                                                
                                                $
                                                22,675
                                                
                                                
                                                $
                                                (1,124
                                                )
                                                
                                                $
                                                70,954
 
 See notes
to condensed consolidated financial statements.
 
 Heritage
Oaks Bancorp | - 6 -
  
 
 Heritage
Oaks Bancorp
 and
Subsidiaries
 Consolidated
Statements of Comprehensive Income
 
 For
      the three months
                              
                              
                              For
      the nine monthsended September 30,
                              
                              
                              ended September 30,(dollars in thousands)
                              
                              2009
                              
                              
                              2008
                              
                              
                              2009
                              
                              
                              2008Net
      (loss) / income
                              
                              $
                              (5,242
                              )
                              
                              $
                              534
                              
                              
                              $
                              (3,633
                              )
                              
                              $
                              2,900Other
      comprehensive gain / (loss) before taxesUnrealized
      gains / (losses) on securities available for sale
                              
                              
                              3,427
                              
                              
                              
                              (953
                              )
                              
                              
                              1,175
                              
                              
                              
                              (2,186
                              )Realized (gains) on sale of available for sale
      securities
                              
                              
                              (211
                              )
                              
                              
                              -
                              
                              
                              
                              (333
                              )
                              
                              
                              (37
                              )Total other comprehensive gain / (loss) before
      taxes
                              
                              
                              3,216
                              
                              
                              
                              (953
                              )
                              
                              
                              842
                              
                              
                              
                              (2,223
                              )Unrealized
      income tax (expense) / benefit related to items in comprehensive (loss) /
      income
                              
                              
                              (1,410
                              )
                              
                              
                              392
                              
                              
                              
                              (483
                              )
                              
                              
                              900Income tax related to the sale of available for
      sale securities
                              
                              
                              87
                              
                              
                              
                              -
                              
                              
                              
                              137
                              
                              
                              
                              15Total other comprehensive income / (loss), net of
      taxes
                              
                              
                              1,893
                              
                              
                              
                              (561
                              )
                              
                              
                              496
                              
                              
                              
                              (1,308
                              )Total comprehensive (loss) /
      income
                              
                              $
                              (3,349
                              )
                              
                              $
                              (27
                              )
                              
                              $
                              (3,137
                              )
                              
                              $
                              1,592
 
 See notes
to condensed consolidated financial statements.
 
 Heritage
Oaks Bancorp | - 7 -
  
 
 Heritage
Oaks Bancorp
 and
Subsidiaries
 Consolidated
Statements of Cash Flows
 
 For
      the nine month periodsended September 30,(dollars in thousands)
                                        
                                        2009
                                        
                                        
                                        2008Cash
      flows from operating activities:Net
      (loss) / income
                                        
                                        $
                                        (3,633
                                        )
                                        
                                        $
                                        2,900Adjustments
      to reconcile net income to net cash provided by operating
      activities:Depreciation
      and amortization
                                        
                                        
                                        844
                                        
                                        
                                        
                                        803Provision
      for possible loan losses
                                        
                                        
                                        14,566
                                        
                                        
                                        
                                        6,215Amortization
      of premiums / discounts on investment securities, net
                                        
                                        
                                        64
                                        
                                        
                                        
                                        (105
                                        )Amortization
      of intangible assets
                                        
                                        
                                        787
                                        
                                        
                                        
                                        645Share-based
      compensation expense
                                        
                                        
                                        269
                                        
                                        
                                        
                                        275Federal
      Home Loan Bank dividends received
                                        
                                        
                                        -
                                        
                                        
                                        
                                        (162
                                        )Gain
      on sale of available for sale securities
                                        
                                        
                                        (333
                                        )
                                        
                                        
                                        (37
                                        )Decrease
      / (increase) in loans held for sale
                                        
                                        
                                        161
                                        
                                        
                                        
                                        (2,053
                                        )Net
      increase in bank owned life insurance
                                        
                                        
                                        (318
                                        )
                                        
                                        
                                        (308
                                        )Increase
      in deferred tax asset
                                        
                                        
                                        (5,017
                                        )
                                        
                                        
                                        (880
                                        )Loss
      on sale and write-downs on other real estate owned
                                        
                                        
                                        1,780
                                        
                                        
                                        
                                        -Increase
      in other assets
                                        
                                        
                                        (8,218
                                        )
                                        
                                        
                                        (823
                                        )Increase
      / (decrease) in other liabilities
                                        
                                        
                                        260
                                        
                                        
                                        
                                        (1,277
                                        )Excess
      tax benefit related to share-based compensation expense
                                        
                                        
                                        (9
                                        )
                                        
                                        
                                        (88
                                        )NET CASH PROVIDED IN OPERATING
      ACTIVITIES
                                        
                                        
                                        1,203
                                        
                                        
                                        
                                        5,105Cash
      flows from investing activities:Purchase
      of securities, available for sale
                                        
                                        
                                        (76,600
                                        )
                                        
                                        
                                        (18,417
                                        )Sale
      of available for sale securities
                                        
                                        
                                        16,040
                                        
                                        
                                        
                                        1,537Maturities
      and calls of available for sale securities
                                        
                                        
                                        1,138
                                        
                                        
                                        
                                        2,186Maturities
      of time deposits with other banks
                                        
                                        
                                        -
                                        
                                        
                                        
                                        211Proceeds
      from principal reductions and maturities of available for sale
      securities
                                        
                                        
                                        8,424
                                        
                                        
                                        
                                        7,535Purchase
      of Federal Home Loan Bank stock
                                        
                                        
                                        (705
                                        )
                                        
                                        
                                        (1,799
                                        )Increase
      in loans, net
                                        
                                        
                                        (38,921
                                        )
                                        
                                        
                                        (55,403
                                        )Allowance
      for loan and lease loss recoveries
                                        
                                        
                                        30
                                        
                                        
                                        
                                        127Purchase
      of property, premises and equipment, net
                                        
                                        
                                        (1,011
                                        )
                                        
                                        
                                        (1,231
                                        )Purchase
      of bank owned life insurance
                                        
                                        
                                        (377
                                        )
                                        
                                        
                                        (400
                                        )Proceeds
      from sale of other real estate owned
                                        
                                        
                                        6,269
                                        
                                        
                                        
                                        -NET CASH (USED) IN INVESTING
      ACTIVITIES
                                        
                                        
                                        (85,713
                                        )
                                        
                                        
                                        (65,654
                                        )Cash
      flows from financing activities:Increase
      / (decrease) in deposits, net
                                        
                                        
                                        150,008
                                        
                                        
                                        
                                        (55,557
                                        )Proceeds
      from Federal Home Loan Bank borrowing
                                        
                                        
                                        75,000
                                        
                                        
                                        
                                        330,000Repayments
      of Federal Home Loan Bank borrowing
                                        
                                        
                                        (119,000
                                        )
                                        
                                        
                                        (231,500
                                        )Decrease
      in repurchase agreements
                                        
                                        
                                        (2,796
                                        )
                                        
                                        
                                        (701
                                        )Excess
      tax benefit related to share-based compensation expense
                                        
                                        
                                        9
                                        
                                        
                                        
                                        88Proceeds
      from exercise of stock options
                                        
                                        
                                        37
                                        
                                        
                                        
                                        140Cash
      dividends paid
                                        
                                        
                                        (424
                                        )
                                        
                                        
                                        (586
                                        )Cash
      paid in lieu of fractional shares
                                        
                                        
                                        -
                                        
                                        
                                        
                                        (5
                                        )Proceeds from issuance of preferred stock and
      common stock warrants, net
                                        
                                        
                                        21,000
                                        
                                        
                                        
                                        -NET CASH PROVIDED BY FINANCING
      ACTIVITIES
                                        
                                        
                                        123,834
                                        
                                        
                                        
                                        41,879Net
      increase / (decrease) in cash and cash equivalents
                                        
                                        
                                        39,324
                                        
                                        
                                        
                                        (18,670
                                        )Cash and cash equivalents, beginning of
      period
                                        
                                        
                                        24,571
                                        
                                        
                                        
                                        46,419Cash and cash equivalents, end of
      period
                                        
                                        $
                                        63,895
                                        
                                        
                                        $
                                        27,749Supplemental
      Cash Flow Disclosures:Cash
      Flow informationInterest
      paid
                                        
                                        $
                                        7,433
                                        
                                        
                                        $
                                        9,927Income
      taxes paid
                                        
                                        $
                                        460
                                        
                                        
                                        $
                                        2,405Non-Cash
      Flow InformationChange
      in other valuation allowance for investment securities
                                        
                                        $
                                        842
                                        
                                        
                                        $
                                        (2,223
                                        )Loans
      transferred to OREO or foreclosed collateral
                                        
                                        $
                                        9,595
                                        
                                        
                                        $
                                        197
 
 See notes
to condensed consolidated financial statements.
 
 Heritage
Oaks Bancorp | - 8 -
  
  Notes to
Consolidated Financial Statements
 
 
 Note
1.  Consolidated Financial Statements
 
 The
accompanying un-audited condensed consolidated financial statements of Heritage
Oaks Bancorp and subsidiaries (the “Company”) have been prepared in accordance
with the instructions to Form 10-Q and Article 10 of Regulation S-X.
Accordingly, certain information and notes required by accounting principles
generally accepted in the United States of America for annual financial
statements are not included herein. In the opinion of Management, all
adjustments (which consist solely of normal recurring accruals) considered
necessary for a fair presentation of results for the interim periods presented
have been included. These interim condensed consolidated financial statements
should be read in conjunction with the financial statements and related notes
contained in the Company’s 2008 Annual Report filed on Form 10-K.
 
 The
condensed consolidated financial statements include the accounts of the Company
and its wholly-owned financial subsidiary, Heritage Oaks Bank (“the
Bank”).  All significant inter-company balances and transactions have
been eliminated. Heritage Oaks Capital Trusts II and III are unconsolidated
subsidiaries formed solely for the purpose of issuing trust preferred
securities. Operating results for the three and nine months ended September 30,
2009 are not necessarily indicative of the results that may be expected for the
year ending December 31, 2009. Certain amounts in the consolidated financial
statements for the year ended December 31, 2008 and for the three and nine
months ended September 30, 2008 may have been reclassified to conform to the
presentation of the consolidated financial statements in 2009.
 
 The
preparation of consolidated financial statements in conformity with the
accounting principles generally accepted in the United States of America
requires Management to make estimates and assumptions.  These
estimates and assumptions affect the reported amounts of assets and liabilities
at the date of the consolidated financial statements and the reported amounts of
revenues and expenses during the reporting period.  Actual results
could differ from these estimates.
 
 Management
evaluated subsequent events through November 6, 2009, the date the financial
statements were available to be issued.  Events or transactions
occurring after September 30, 2009, but prior to November 6, 2009 that
provided additional evidence about conditions that existed at September 30,
2009, have been recognized in the financial statements for the quarter ended
September 30, 2009.  Events or transactions that provided
evidence about conditions that did not exist at September 30, 2009, but
arose before the financial statements were available to be issued have not been
recognized in the financial statements for the period ended September 30,
2009.
 
 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 | - 9 -
  
  Notes to
Consolidated Financial Statements
 
 The
following table sets forth the amortized cost and fair values of investment
securities available for sale at September 30, 2009 and December 31,
2008:
 
 (dollars
      in thousands)
                                  
                                  
                                  
                                  
                                  Gross
                                  
                                  
                                  GrossAmortized
                                  
                                  
                                  Unrealized
                                  
                                  
                                  Unrealized
                                  
                                  
                                  FairAs of September 30, 2009
                                  
                                  Cost
                                  
                                  
                                  Gains
                                  
                                  
                                  Losses
                                  
                                  
                                  ValueObligations
      of U.S. government agencies and corporations
                                  
                                  $
                                  110
                                  
                                  
                                  $
                                  -
                                  
                                  
                                  $
                                  (4
                                  )
                                  
                                  $
                                  106Mortgage
      backed securities
                                  
                                  
                                  81,644
                                  
                                  
                                  
                                  1,861
                                  
                                  
                                  
                                  (4,034
                                  )
                                  
                                  
                                  79,471Obligations
      of state and political subdivisions
                                  
                                  
                                  22,021
                                  
                                  
                                  
                                  1,165
                                  
                                  
                                  
                                  (1
                                  )
                                  
                                  
                                  23,185Other securities
                                  
                                  
                                  109
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  109Total
                                  
                                  $
                                  103,884
                                  
                                  
                                  $
                                  3,026
                                  
                                  
                                  $
                                  (4,039
                                  )
                                  
                                  $
                                  102,871As of December 31, 2008Obligations
      of U.S. government agencies and corporations
                                  
                                  $
                                  149
                                  
                                  
                                  $
                                  -
                                  
                                  
                                  $
                                  (1
                                  )
                                  
                                  $
                                  148Mortgage-backed
      securities
                                  
                                  
                                  35,339
                                  
                                  
                                  
                                  166
                                  
                                  
                                  
                                  (2,102
                                  )
                                  
                                  
                                  33,403Obligations
      of state and political subdivisions
                                  
                                  
                                  17,020
                                  
                                  
                                  
                                  373
                                  
                                  
                                  
                                  (291
                                  )
                                  
                                  
                                  17,102Other securities
                                  
                                  
                                  109
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  109Total
                                  
                                  $
                                  52,617
                                  
                                  
                                  $
                                  539
                                  
                                  
                                  $
                                  (2,394
                                  )
                                  
                                  $
                                  50,762
 
 During
the three months ended September 30, 2009 the Bank sold approximately $11.3
million in investment securities.  In connection with these sales, the
Bank recognized a gain of approximately $0.2 million.  Sales of
investment securities during the first nine months of 2009 totaled approximately
$16.0 million.  Gains recognized in connection with these sales
totaled approximately $0.3 million.  During the first nine months of
2008, the Bank sold approximately $5.2 million in securities and recognized a
pre-tax gain of $37 thousand.
 
 The
following table provides a summary of investment securities in an unrealized
loss position as of September 30, 2009:
 
 Securities
      In A Loss Position(dollars
      in thousands)
                          
                          For
      Less Than 12 Months
                          
                          
                          For
      12 Months or More
                          
                          
                          TotalFair
                          
                          
                          Unrealized
                          
                          
                          Fair
                          
                          
                          Unrealized
                          
                          
                          Fair
                          
                          
                          UnrealizedAs
      of September 30, 2009
                          
                          Value
                          
                          
                          Loss
                          
                          
                          Value
                          
                          
                          Loss
                          
                          
                          Value
                          
                          
                          LossObligations
      of U.S. government agencies and corporations
                          
                          $
                          -
                          
                          
                          $
                          -
                          
                          
                          $
                          106
                          
                          
                          $
                          (4
                          )
                          
                          $
                          106
                          
                          
                          $
                          (4
                          )Mortgage-backed
      securities
                          
                          
                          21,341
                          
                          
                          
                          (793
                          )
                          
                          
                          11,862
                          
                          
                          
                          (3,241
                          )
                          
                          
                          33,203
                          
                          
                          
                          (4,034
                          )Obligations
      of state and political subdivisions
                          
                          
                          146
                          
                          
                          
                          (1
                          )
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          146
                          
                          
                          
                          (1
                          )Other
      securities
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Total
                          
                          $
                          21,487
                          
                          
                          $
                          (794
                          )
                          
                          $
                          11,968
                          
                          
                          $
                          (3,245
                          )
                          
                          $
                          33,455
                          
                          
                          $
                          (4,039
                          )
 
 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.
 
 At
September 30, 2009, the Bank owned twelve Whole Loan Private Label Mortgage
Backed Securities (“PMBS”) with a principal balance of approximately $23.4
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.  At September 30, 2009, six bonds in the
approximate amount of $14.7 million, have been 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 more credit support or enhancement, the more protection is
provided from possible losses on non-performing collateral and the credit
enhancement has actually increased from the original amount through September
30, 2009 on all but one bond.  As the Bank receives cash flow on its
senior position and principle is reduced quicker than default losses are applied
to the subordinate positions, the credit enhancement percentage
grows.
 
 Heritage
Oaks Bancorp | - 10 -
  
  Notes to
Consolidated Financial Statements
 
 The Bank
continues to perform extensive analyses on the PMBS bonds in the portfolio.
These investment securities, including the six downgraded bonds mentioned above,
continue to demonstrate cash flows as expected, based on pre-purchase analyses,
and the credit support component of these tranches has actually increased from
the origination date through September 30, 2009.  As of September 30,
2009, Management does not believe unrealized losses in the investment portfolio
are other than temporary.
 
 Note
3.  Loans and the Allowance for Loan Losses
 
 The
following table provides a summary of outstanding loan balances as of September
30, 2009 compared to December 31, 2008:
 
 September
      30,
                              
                              
                              December
      31,(dollars in thousands)
                              
                              2009
                              
                              
                              2008Real
      Estate SecuredMulti-family
      residential
                              
                              $
                              17,323
                              
                              
                              $
                              16,206Residential
      1 to 4 family
                              
                              
                              24,580
                              
                              
                              
                              23,910Home
      equity lines of credit
                              
                              
                              29,189
                              
                              
                              
                              26,409Commercial
                              
                              
                              317,811
                              
                              
                              
                              285,631Farmland
                              
                              
                              9,842
                              
                              
                              
                              10,723CommercialCommercial
      and industrial
                              
                              
                              166,618
                              
                              
                              
                              157,674Agriculture
                              
                              
                              14,819
                              
                              
                              
                              13,744Other
                              
                              
                              368
                              
                              
                              
                              620ConstructionSingle
      family residential
                              
                              
                              14,669
                              
                              
                              
                              11,414Single
      family residential - Spec.
                              
                              
                              5,757
                              
                              
                              
                              15,395Tract
                              
                              
                              2,215
                              
                              
                              
                              2,431Multi-family
                              
                              
                              5,575
                              
                              
                              
                              5,808Hospitality
                              
                              
                              14,252
                              
                              
                              
                              18,630Commercial
                              
                              
                              22,997
                              
                              
                              
                              21,484Land
                              
                              
                              54,619
                              
                              
                              
                              61,681Installment
      loans to individuals
                              
                              
                              8,863
                              
                              
                              
                              7,851All
      other loans (including overdrafts)
                              
                              
                              370
                              
                              
                              
                              536Total loans, gross
                              
                              
                              709,867
                              
                              
                              
                              680,147Deferred
      loan fees
                              
                              
                              1,635
                              
                              
                              
                              1,701Allowance for loan losses
                              
                              
                              15,873
                              
                              
                              
                              10,412Total loans, net
                              
                              $
                              692,359
                              
                              
                              $
                              668,034Loans
      held for sale
                              
                              
                              7,778
                              
                              
                              
                              7,939
 
 Concentration
of Credit Risk
 
 At
September 30, 2009, approximately $518.8 million or 73.1% of the Bank’s loan
portfolio was collateralized by various forms of real estate, this represents an
increase of approximately $19.1 million when compared to the $499.7 million or
73.5% reported at December 31, 2008.  Such loans are generally made to
borrowers located in San Luis Obispo and Santa Barbara Counties. The Bank
attempts to reduce its concentration of credit risk by making loans which are
diversified by industry and project type.  While Management believes
that the collateral presently securing this portfolio is adequate, there can be
no assurances that further significant deterioration in the California real
estate market would not expose the Bank to significantly greater credit
risk.
 
 At
September 30, 2009, the Bank was contingently liable for letters of credit
accommodations made to its customers totaling approximately $17.7 million and
un-disbursed loan commitments in the approximate amount of $185.9 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 | - 11 -
  
  Notes to
Consolidated Financial Statements
 
 Allowance
for Loan Losses
 
 An
allowance for loan losses has been established by Management to provide for
those loans that may not be repaid in their entirety for a variety of
reasons.  The allowance is maintained at a level considered by
Management to be adequate to provide for probable incurred
losses.  The allowance is increased by provisions charged to earnings
and is reduced by charge-offs, net of recoveries. The provision for loan losses
is based upon past loan loss experience and Management’s evaluation of the loan
portfolio under current economic conditions.  Loans are charged to the
allowance for loan losses when, and to the extent, they are deemed by Management
to be un-collectible.
 
 The
following table provides a summary for the activity in the allowance for loan
losses during the periods indicated:
 
 For
      the three months ended
                            
                            
                            For
      the nine months ended
                            
                            
                            For
      the year endedSeptember 30,
                            
                            
                            September 30,
                            
                            
                            December 31,(dollars in thousands)
                            
                            2009
                            
                            
                            2008
                            
                            
                            2009
                            
                            
                            2008
                            
                            
                            2008Balance
      at beginning of period
                            
                            $
                            11,106
                            
                            
                            $
                            8,128
                            
                            
                            $
                            10,412
                            
                            
                            $
                            6,143
                            
                            
                            $
                            6,143Provision
      expense
                            
                            
                            9,756
                            
                            
                            
                            3,200
                            
                            
                            
                            14,566
                            
                            
                            
                            6,215
                            
                            
                            
                            12,215Loans
      charged-offCommercial
      real estate
                            
                            
                            41
                            
                            
                            
                            -
                            
                            
                            
                            41
                            
                            
                            
                            305
                            
                            
                            
                            340Residential
      1-4 family
                            
                            
                            304
                            
                            
                            
                            -
                            
                            
                            
                            304
                            
                            
                            
                            -
                            
                            
                            
                            555Commercial
      and industrial
                            
                            
                            503
                            
                            
                            
                            282
                            
                            
                            
                            1,728
                            
                            
                            
                            849
                            
                            
                            
                            3,854Agriculture
                            
                            
                            1,909
                            
                            
                            
                            -
                            
                            
                            
                            1,909
                            
                            
                            
                            -
                            
                            
                            
                            -Construction
                            
                            
                            397
                            
                            
                            
                            717
                            
                            
                            
                            2,218
                            
                            
                            
                            923
                            
                            
                            
                            1,837Land
                            
                            
                            1,801
                            
                            
                            
                            -
                            
                            
                            
                            2,792
                            
                            
                            
                            -
                            
                            
                            
                            1,434Other
                            
                            
                            42
                            
                            
                            
                            34
                            
                            
                            
                            143
                            
                            
                            
                            58
                            
                            
                            
                            56Total charge-offs
                            
                            
                            4,997
                            
                            
                            
                            1,033
                            
                            
                            
                            9,135
                            
                            
                            
                            2,135
                            
                            
                            
                            8,076Recoveries of loans previously charged
      off
                            
                            
                            8
                            
                            
                            
                            55
                            
                            
                            
                            30
                            
                            
                            
                            127
                            
                            
                            
                            130Balance at end of period
                            
                            $
                            15,873
                            
                            
                            $
                            10,350
                            
                            
                            $
                            15,873
                            
                            
                            $
                            10,350
                            
                            
                            $
                            10,412
 
 During
the three and nine months ended September 30, 2009, the Company made provisions
for loan losses in the amounts of $9.8 million and $14.6 million,
respectively.  This when compared to the $3.2 million and $6.2 million
reported for the same periods ended a year earlier, represents respective
increases of approximately $6.6 million and $8.4 million.  Elevated
provision expenses are reflective of, among other things, additional loan
balances charged-off during the first nine months of 2009, continued weakness in
local, state and national economic conditions and the number and dollar volume
of loans placed on non-accruing status when compared to the same period ended in
2008.
 
 Note
4.  Earnings Per Share
 
 Basic
earnings per common share are computed by dividing net income available to
common shareholders by the weighted-average number of common shares outstanding
for the reporting period.  Diluted earnings 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 and other share-based compensation awards, exclusive
of any award that may have an anti-dilutive affect on earnings per common
share.  As disclosed in Note 9 of these consolidated financial
statements, the Company issued a warrant to the U.S. Treasury to purchase
611,650 shares of its common stock.  The warrant was not included in
the Company’s calculation of diluted earnings per common share for the three and
nine months ended September 30, 2009, since it was anti-dilutive.
 
 Heritage
Oaks Bancorp | - 12 -
  
  Notes to
Consolidated Financial Statements
 
 The
following table sets forth the number of shares used in the calculation of both
basic and diluted earnings per share for the three months ended September 30,
2009 and 2008:
 
 For the three months
ending,September 30, 2009
                                    
                                    
                                    September 30, 2008Net
                                    
                                    
                                    
                                    
                                    
                                    Net(dollar amounts in thousands except per share
      data)
                                    
                                    Income
                                    
                                    
                                    Shares
                                    
                                    
                                    Income
                                    
                                    
                                    SharesNet
      (loss) / income
                                    
                                    $
                                    (5,242
                                    )
                                    
                                    
                                    
                                    
                                    $
                                    534Dividends
      and accretion on preferred stock
                                    
                                    
                                    (352
                                    )
                                    
                                    
                                    
                                    
                                    
                                    -Net
      (loss) / income available to common shareholders
                                    
                                    $
                                    (5,594
                                    )
                                    
                                    
                                    
                                    
                                    $
                                    534Weighted average shares
      outstanding
                                    
                                    
                                    
                                    
                                    
                                    
                                    7,699,377
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    7,709,600Basic (loss) / earnings per common
      share
                                    
                                    $
                                    (0.73
                                    )
                                    
                                    
                                    
                                    
                                    
                                    $
                                    0.07Dilutive
      effect of share-based compensation awards
                                    
                                    
                                    
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    88,721Dilutive effect of common stock
      warrant
                                    
                                    
                                    
                                    
                                    
                                    
                                    -
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    -Weighted average diluted shares
      outstanding
                                    
                                    
                                    
                                    
                                    
                                    
                                    7,699,377
                                    
                                    
                                    
                                    
                                    
                                    
                                    
                                    7,798,321Diluted (loss) / earnings per common
      share
                                    
                                    $
                                    (0.73
                                    )
                                    
                                    
                                    
                                    
                                    
                                    $
                                    0.07
 
 The
following table sets forth the number of shares used in the calculation of both
basic and diluted earnings per share for the nine months ended September 30,
2009 and 2008:
 
 For the nine months ending,September 30, 2009
                                      
                                      
                                      September 30, 2008Net
                                      
                                      
                                      
                                      
                                      
                                      Net(dollar amounts in thousands except per share
      data)
                                      
                                      Income
                                      
                                      
                                      Shares
                                      
                                      
                                      Income
                                      
                                      
                                      SharesNet
      (loss) / income
                                      
                                      $
                                      (3,633
                                      )
                                      
                                      
                                      
                                      
                                      $
                                      2,900Dividends
      and accretion on preferred stock
                                      
                                      
                                      (613
                                      )
                                      
                                      
                                      
                                      
                                      
                                      -Net
      (loss) / income available to common shareholders
                                      
                                      $
                                      (4,246
                                      )
                                      
                                      
                                      
                                      
                                      $
                                      2,900Weighted average shares
      outstanding
                                      
                                      
                                      
                                      
                                      
                                      
                                      7,694,969
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      7,703,107Basic (loss) / earnings per common
      share
                                      
                                      $
                                      (0.56
                                      )
                                      
                                      
                                      
                                      
                                      
                                      $
                                      0.38Dilutive
      effect of share-based compensation awards
                                      
                                      
                                      
                                      
                                      
                                      
                                      -
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      129,708Dilutive effect of common stock
      warrant
                                      
                                      
                                      
                                      
                                      
                                      
                                      -
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      -Weighted average diluted shares
      outstanding
                                      
                                      
                                      
                                      
                                      
                                      
                                      7,694,969
                                      
                                      
                                      
                                      
                                      
                                      
                                      
                                      7,832,815Diluted (loss) / earnings per common
      share
                                      
                                      $
                                      (0.56
                                      )
                                      
                                      
                                      
                                      
                                      
                                      $
                                      0.37
 
 On April
24, 2008, the Company’s Board of Directors declared a 5% stock dividend which
was paid on May 16, 2008.  As a result of this dividend, the Company
issued 366,294 shares of its common stock to holders of record on May 2,
2008.  The basic and diluted shares presented in the tables above as
well as shares for all prior periods have been adjusted to fully reflect the May
2008 stock dividend.
 
 Note
5.  Recent Accounting Pronouncements
 
 In June
2009, the Financial Accounting Standards Board (“FASB”) issued an accounting
standard regarding The FASB
Accounting Standards CodificationTM
(“Codification” or “ASC”) that will become the source of authoritative U.S.
generally accepted accounting principles (“GAAP”) recognized by the FASB to be
applied by nongovernmental entities. Rules and interpretive releases of the
Securities and Exchange Commission (“SEC”) under authority of federal securities
laws are also sources of authoritative GAAP for SEC registrants.  On
the effective date of this standard, all interim and annual reporting periods
ending after September 15, 2009, the Codification will supersede all
then-existing non-SEC accounting and reporting standards. All other
non-grandfathered non-SEC accounting literature not included in the Codification
will become non-authoritative.  The adoption of this standard did not
have a material impact on the Company’s financial statements.
 
 Heritage
Oaks Bancorp | - 13 -
  
  Notes to
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 a
variable interest entity as the company that has both of the following
characteristics: (a) the power to direct the activities of a variable interest
entity that most significantly impact the company’s economic performance; and
(b) the obligation to absorb losses of the entity that could potentially be
significant to the variable interest entity or the right to receive benefits
from the entity that could potentially be significant to the variable interest
entity.  This standard is effective for all annual and interim
reporting periods beginning after November 15, 2009 with earlier application
prohibited.  The Company has not yet determined the impact that this
standard will have on its 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 is
required to adopt this standard for all interim and annual reporting periods
beginning after November 15, 2009.  The Company does not currently
expect the adoption of this standard to have a material impact on its financial
statements.
 
 In May
2009, the FASB issued an accounting standard which was incorporated into ASC
topic 855 “Subsequent Events.”  This standard sets forth principles
and requirements for disclosing and recognizing subsequent events in the
financial statements.  This standard also outlines circumstances under
which an entity shall recognize those events or transactions occurring after the
balance sheet date.  The Company is required to adopt this standard
for all interim and annual reporting periods after June 15, 2009,
prospectively.  The Company’s adoption of this standard did not have a
material impact on its financial statements.
 
 In April
2009, the FASB issued the following accounting standards (subsequently
incorporated into the Accounting Standards Codification):
 
 The FASB
issued an accounting standard which was incorporated into ASC topic 820 “Fair
Value Measurements and Disclosures.”  This standard provides
guidelines for making fair value measurements more consistent. This standard
provides additional authoritative guidance in determining whether a market is
active or inactive, and whether a transaction is distressed, is applicable to
all assets and liabilities (i.e. financial and nonfinancial) and will require
enhanced disclosures.
 
 The FASB
issued accounting standards which were subsequently incorporated into ASC topics
320 “Investments – Debt and Equity Securities” and 835
“Interest.”  These standards seek to make the other-than-temporary
impairment guidance more operational and to improve the presentation of
other-than-temporary impairments in the financial statements.  These
standards apply to other-than-temporary impairments of debt and equity
securities and requires a company to assert that (a) it does not have the intent
to sell the security in question and (b) it is more likely than not that it will
not have to sell the security in question before recovery of its cost basis to
avoid an impairment being considered other-than-temporary.  These
standards also change the amount of impairment losses recognized in
earnings.  Under these standards impairments are separated into two
components: (i) the amount of impairments related to credit losses and (ii) and
the amount related to other factors.  The amount of impairment related
to credit losses is reflected as a charge to earnings, while the amount deemed
to be related to other factors is reflected as an adjustment to shareholders’
equity through other comprehensive income.
 
 The FASB
issued accounting standards which were subsequently incorporated into ASC topic
825 “Financial Instruments.” These standards require disclosures about fair
value of financial instruments in interim as well as in annual financial
statements.
 
 The
accounting guidance summarized in the preceding paragraphs is effective for
periods ending after June 15, 2009.  The adoption of which has not had
a material impact in the Company’s financial statements.
 
 On April
1, 2009, the FASB issued an accounting standard which was subsequently
incorporated into ASC topic 805 “Business Combinations.”This standard provides
additional guidance regarding the recognition, measurement and disclosure of
assets and liabilities arising from contingencies in a business
combination.  This standard is effective for assets or liabilities
arising from contingencies in business combinations for which the acquisition
date is on or after the beginning of the first annual reporting period beginning
on or after December 15, 2008.  The standard also addresses other
accounting issues regarding business combinations including the measurement of
acquirer shares issued in consideration for a business combination, the
recognition of contingent consideration, the accounting for pre-acquisition gain
and loss contingencies, the recognition of capitalized in-process research and
development, the accounting for acquisition-related restructuring cost accruals,
the treatment of acquisition related transaction costs and the recognition of
changes in the acquirer’s income tax valuation allowance. The impact of adopting
this standard will depend on the timing of future acquisitions, as well as the
nature and existence of contingencies associated with such
acquisitions.
 
 Heritage
Oaks Bancorp | - 14 -
  
  Notes to
Consolidated 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 required to adopt this standard no later than
January 1, 2010.  The Company does not believe the adoption of this
standard will have a material impact on its financial statements.
 
 On
October 10, 2008, the FASB issued an accounting standard which was subsequently
incorporated into ASC topic 820 “Fair Value Measurements and Disclosures.” The
standard clarifies the application of accounting guidance for fair value
measurements in a market that is not active and provides an example to
illustrate key considerations in determining the fair value of a financial asset
when the market for that financial asset is not active. The standard is
effective immediately, and includes prior periods for which financial statements
have not been issued, and therefore the Company is subject to the provisions
under the standard effective September 30, 2008. The implementation of this
standard did not affect the Company's fair value measurements as of September
30, 2009.
 In June
2008, the FASB issued an accounting standard which was subsequently incorporated
into ASC topic 260 “Earnings Per Share.”  The standard addresses
whether instruments granted in share-based payment transactions are
participating securities prior to vesting and, therefore, need to be included in
the earnings allocation in computing EPS under the two-class method. This
standard affects entities that accrue cash dividends on share-based payment
awards during the awards' service period when the dividends do not need to be
returned if the employees forfeit the awards.  This standard is
effective for fiscal years beginning after December 15,
2008.  The adoption of this standard did not have material impact on
the Company’s financial position, results of operations or cash
flows.
 In May
2008, the FASB issued an accounting standard which was subsequently incorporated
into ASC topic 944 “Financial Services – Insurance.”   This
standard seeks to bring consistency in the recognition and measurement of claim
liabilities.  This standard applies to financial guarantee contracts,
including the recognition and measurement to be used to account for premium
revenue and claim liabilities, increasing the comparability in financial
reporting of financial guarantee contracts by insurance
enterprises.  The Company adopted the standard on January 1,
2009.  The Company’s adoption of this standard did not have a material
impact on its financial position, results of operations or cash
flows.
 
 In March
2008, the FASB issued an accounting standard which was subsequently incorporated
into ASC topic 815 “Derivatives and Hedging.”  This standard seeks to
provide users of financial statements with an enhanced understanding of: how and
why an entity uses derivative instruments; how derivative instruments and
related hedged items are accounted for and how derivative instruments and
related hedged items affect an entity’s financial position, results of
operations, and cash flows.  This standard requires qualitative
disclosures about objectives and strategies for using derivatives, quantitative
disclosures about fair value amounts of and gains and losses on derivative
instruments, and disclosures about credit-risk-related contingent features in
derivative agreements. This standard is effective for fiscal years and interim
periods beginning after November 15, 2008. The Company’s adoption of this
standard did not have a material impact on its financial position, results of
operations or cash flows.
 
 In
December 2007, the FASB issued an accounting standard which was subsequently
incorporated into ASC topic 810 “Consolidation.”  This standard
addresses the accounting for non-controlling (minority) interests in
consolidated financial statements including the requirements to classify
non-controlling interests as a component of consolidated stockholders’ equity,
and the elimination of “minority interest” accounting in results of operations
with earnings attributable to non-controlling interests reported as part of
consolidated earnings.  The Company adopted this standard on January
1, 2009, the adoption of which did not have a material impact on the Company’s
financial position, results of operations or cash flows.
 
 Heritage
Oaks Bancorp | - 15 -
  
  Notes to
Consolidated Financial Statements
 
 Note
6.  Share-Based Compensation
 
 As of
September 30, 2009, the Company had two share-based employee compensation plans,
which are more fully described in Note 14 of the Consolidated Financial
Statements in the Company's Annual Report filed on Form 10-K for the year ended
December 31, 2008. These plans include the “1997 Stock Option Plan” and the
“2005 Equity Based Compensation Plan.” Share-based compensation expense for all
share-based compensation awards granted after January 1, 2006, is based on the
grant-date fair value. For all awards except stock option awards, the grant date
fair value is either the fair market value per share or book value per share
(corresponding to the type of stock awarded) as of the grant
date.  For stock option awards, the grant date fair value is estimated
using the Black-Scholes option pricing model. For all awards, the Company
recognizes these compensation costs only for those shares expected to vest on a
straight-line basis over the requisite service period of the award, for which we
use the related vesting term.  The Company estimates forfeiture rates
based on historical employee option exercise and employee termination
experience.
 
 The
share-based compensation expense recognized in the consolidated statements of
income for the three and nine month periods ended September 30, 2009 and 2008 is
based on awards ultimately expected to vest, and accordingly has been adjusted
by the amount of estimated forfeitures.  U.S. GAAP requires
forfeitures to be estimated at the time of grant and revised, if necessary, in
subsequent periods if actual forfeitures differ from those
estimates.
 
 The
following table provides a summary of the expenses the Company has recognized
related to share-based compensation as well as the impact those expenses have
had on diluted earnings per share for the periods indicated below:
 
 For
      the three months ended
                                      
                                      
                                      For
      the nine months endedSeptember 30,
                                      
                                      
                                      September 30,(dollars in thousands except share and per share
      data)
                                      
                                      2009
                                      
                                      
                                      2008
                                      
                                      
                                      2009
                                      
                                      
                                      2008Share-based
      compensation expense:Stock
      option expense
                                      
                                      $
                                      43
                                      
                                      
                                      $
                                      51
                                      
                                      
                                      $
                                      129
                                      
                                      
                                      $
                                      152Restricted stock expense
                                      
                                      
                                      42
                                      
                                      
                                      
                                      57
                                      
                                      
                                      
                                      140
                                      
                                      
                                      
                                      123Total share-based compensation
      expense
                                      
                                      
                                      85
                                      
                                      
                                      $
                                      108
                                      
                                      
                                      
                                      269
                                      
                                      
                                      $
                                      275Total share-based compensation expense, net of
      tax
                                      
                                      $
                                      52
                                      
                                      
                                      $
                                      72
                                      
                                      
                                      $
                                      165
                                      
                                      
                                      $
                                      186Diluted
      shares outstanding
                                      
                                      
                                      7,699,377
                                      
                                      
                                      
                                      7,798,321
                                      
                                      
                                      
                                      7,694,969
                                      
                                      
                                      
                                      7,832,815Impact on diluted earnings per
      share
                                      
                                      $
                                      -
                                      
                                      
                                      $
                                      0.009
                                      
                                      
                                      $
                                      -
                                      
                                      
                                      $
                                      0.024Unrecognized
      compensation expense:Stock
      option expense
                                      
                                      $
                                      274
                                      
                                      
                                      $
                                      315Restricted stock expense
                                      
                                      
                                      307
                                      
                                      
                                      
                                      547Total unrecognized share-based compensation
      expense
                                      
                                      $
                                      581
                                      
                                      
                                      $
                                      862Total unrecognized share-based compensation
      expense, net of tax
                                      
                                      $
                                      376
                                      
                                      
                                      $
                                      525
 
 At
September 30, 2009, there was a total of $274 thousand of unrecognized
compensation expense related to non-vested stock option awards. That expense is
expected to be recognized over a weighted-average period of 2.3
years.
 
 The
Company grants restricted share awards periodically for the benefit of
employees. These restricted shares generally “cliff vest” after five years of
issuance. Recipients of restricted shares have the right to vote all shares
subject to such grant, and receive all dividends with respect to such shares,
whether or not the shares have vested. Recipients do not pay any cash
consideration for the shares.  The total unrecognized compensation
expense related to restricted share awards at September 30, 2009 was $307
thousand. That expense is expected to be recognized over the next 1.4
years.
 
 The
aggregate intrinsic value in the table below represents the total pretax
intrinsic value (the difference between the Company’s closing stock price on the
last trading day of the third quarter of 2009 and the exercise price, multiplied
by the number of in-the-money options that would have been received by the
option holders had all option holders exercised their options on September 30,
2009).  The aggregate pretax intrinsic value is subject to change
based on the fair market value of the Company's stock.  The aggregate
intrinsic value of options exercised for the nine month period ended September
30, 2009 was $22 thousand.  The aggregate intrinsic value of options
exercised during the nine month period ended September 30, 2008 was $214
thousand.  There were no options exercised during the three months
ended September 30, 2009 and 2008.
 
 Heritage
Oaks Bancorp | - 16 -
  
  Notes to
Consolidated Financial Statements
 
 The
following table provides a summary of the aggregate intrinsic value of options
outstanding and exercisable as well as options granted, exercised, and forfeited
during the year-to-date periods ended September 30, 2009 and 2008:
 
 AverageWeighted
                                            
                                            
                                            Remaining
                                            
                                            
                                            TotalAverage
                                            
                                            
                                            Contractual
                                            
                                            
                                            IntrinsicNumber
      of
                                            
                                            
                                            Exercise
                                            
                                            
                                            Term
                                            
                                            
                                            ValueShares
                                            
                                            
                                            Price
                                            
                                            
                                            (in years)
                                            
                                            
                                            (in 000's)Options
      outstanding, January 1, 2009
                                            
                                            
                                            408,830
                                            
                                            
                                            $
                                            9.34Granted
                                            
                                            
                                            49,741
                                            
                                            
                                            
                                            5.41Exercised
                                            
                                            
                                            (10,050
                                            )
                                            
                                            
                                            3.73Options outstanding, September 30,
      2009
                                            
                                            
                                            448,521
                                            
                                            
                                            $
                                            9.03
                                            
                                            
                                            
                                            4.33
                                            
                                            
                                            $
                                            484Exercisable at September 30,
      2009
                                            
                                            
                                            347,172
                                            
                                            
                                            $
                                            8.92
                                            
                                            
                                            
                                            3.03
                                            
                                            
                                            $
                                            385Options
      outstanding, January 1, 2008
                                            
                                            
                                            463,160
                                            
                                            
                                            $
                                            8.36Granted
                                            
                                            
                                            26,250
                                            
                                            
                                            
                                            11.48Exercised
                                            
                                            
                                            (32,090
                                            )
                                            
                                            
                                            4.37Forfeited
                                            
                                            
                                            (7,912
                                            )
                                            
                                            
                                            8.20Options outstanding, September 30,
      2008
                                            
                                            
                                            449,408
                                            
                                            
                                            $
                                            8.83
                                            
                                            
                                            
                                            4.15
                                            
                                            
                                            $
                                            622Exercisable at September 30,
      2008
                                            
                                            
                                            358,673
                                            
                                            
                                            $
                                            7.76
                                            
                                            
                                            
                                            3.10
                                            
                                            
                                            $
                                            622
 
 During
the first nine months of 2009, the Company granted 49,741 options to various
non-management members of the Company’s Board of Directors as well as to certain
officers of the Bank.  Of the options granted in 2009, 25,000 were
granted to non-management members of the Company’s Board of
Directors.  Similar grants were made to the Company’s Board of
Directors during the first quarter of 2008.  The following table
presents the assumptions used in the calculation of the weighted average fair
value of options granted during 2009 and 2008 on the date of grant using the
Black-Scholes options pricing model:
 
 2009
                          
                          
                          2008Expected
      volatility
                          
                          
                          37.66
                          %
                          
                          
                          35.07
                          %Expected
      term (years)
                          
                          
                          10
                          
                          
                          
                          10Dividend
      yield
                          
                          
                          0.00
                          %
                          
                          
                          2.66
                          %Risk free rate
                          
                          
                          3.16
                          %
                          
                          
                          3.62
                          %Weighted-average grant date fair
      value
                          
                          $
                          2.87
                          
                          
                          $
                          3.93
 
 The
Black-Scholes model incorporates a range of assumptions for inputs that are
disclosed in the table above.  Expected volatilities are based on,
among other things, the daily historical stock price over the expected life of
the option.  The expected term of options granted is derived from the
output of the model and represents the period of time that options granted are
expected to be outstanding.  Dividend yields are estimated based on
the dividend yield on the Company’s common stock at the time of
grant.  The risk-free rate for periods within the contractual life of
the stock option is based on the U.S. Treasury yield curve in effect at the time
of grant.
 
 Estimates
of fair value derived from the Company’s use of the Black-Scholes pricing model
are theoretical values for stock options and changes in the assumptions used in
the models could result in different fair value estimates.  The actual
value of the stock options granted will depend on the market value of the
Company’s common stock when the options are exercised.
 
 Heritage
Oaks Bancorp | - 17 -
  
  Notes to
Consolidated Financial Statements
 
 Note
7.  Fair Value Disclosures
 
 Effective
January 1, 2008, the Company determines the fair market values of certain
financial instruments based on the fair value hierarchy established in U.S. GAAP
under Accounting Standard Codification (“ASC”) topic 820, “Fair Value
Measurements and Disclosures.  U.S GAAP 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 (“CDO”) where independent pricing information was not able to be
obtained for a significant portion of the underlying assets.
 
 Fair
Value Measurements
 
 The
Company used the following methods and significant assumptions to estimate fair
value:
 
 Securities
 
 The fair
value of securities available-for-sale are determined by obtaining quoted prices
on nationally recognized exchanges or matrix pricing which is a mathematical
technique used widely in the industry to value debt securities without relying
exclusively on quoted prices for the specific securities but rather relying on
the security’s relationship to other benchmark quoted securities.
 
 Loans
Held For Sale
 
 The fair
value of loans held for sale is determined, when possible, using quoted
secondary market prices. If no such quoted price exists, the fair value of the
loan is determined using quoted prices for a similar asset or assets, adjusted
for the specific attributes of that loan.
 
 Impaired
Loans
 
 A loan is
considered impaired when it is probable that payment of interest and principal
will not be made in accordance with the contractual terms of the loan
agreement.  Impairment is measured based on the fair value of the
underlying collateral or the discounted expected future cash
flows.  The Company measures impairment on all non-accruing loans for
which it has established specific reserves as part of the specific allocated
allowance component of the allowance for loan losses.  As such, the
Company records impaired loans as non-recurring Level 2 when the fair value of
the underlying collateral is based on an observable market price or current
appraised value.  When current market prices are not available or the
Company determines that the fair value of the underlying collateral is further
impaired below appraised values, the Company records impaired loans as
non-recurring Level 3.  At September 30, 2009, substantially all of
the Company’s impaired loans were evaluated based on the fair value of their
underlying collateral with the most recent appraisal available to
Management.
 
 Heritage
Oaks Bancorp | - 18 -






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 September 30,
2009:
 
 Fair Value Measurments
UsingAssets
      At(dollars in thousands)
                          
                          Level 1
                          
                          
                          Level 2
                          
                          
                          Level 3
                          
                          
                          Fair ValueAssets:Available for sale investment
      securities
                          
                          $
                          -
                          
                          
                          $
                          102,127
                          
                          
                          $
                          744
                          
                          
                          $
                          102,871Total assets measured on a recurring
      basis
                          
                          $
                          -
                          
                          
                          $
                          102,127
                          
                          
                          $
                          744
                          
                          
                          $
                          102,871
 
 The
following table provides a summary of the changes in balance sheet carrying
values associated with Level 3 financial instruments during the nine months
ended September 30, 2009:
 
 Available
      ForSale
      Investment(dollars in thousands)
                                
                                SecuritiesBeginning
      balance
                                
                                $
                                774Total
      gains or losses (realized/unrealized)(1):Included
      in earnings
                                
                                
                                -Included
      in other comprehensive loss
                                
                                
                                (30
                                )Purchases
                                
                                
                                -Transfers
      in and/or out of Level 3
                                
                                
                                -Non-trading
      activity
                                
                                
                                -Ending balance
                                
                                $
                                744
 (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 represent available
for sale investment securities in the form of certificates of participation
where an active market for such securities is not currently
available.
 
 The
following table provides a summary of the financial instruments the Company
measures at fair value on a non-recurring basis as of September 30,
2009:
 Fair Value Measurments
UsingAssets
      At(dollars in thousands)
                          
                          Level 1
                          
                          
                          Level 2
                          
                          
                          Level 3
                          
                          
                          Fair ValueAssets:Impaired
      loans
                          
                          $
                          -
                          
                          
                          $
                          39,135
                          
                          
                          $
                          -
                          
                          
                          $
                          39,135Loans
      held for sale
                          
                          
                          -
                          
                          
                          
                          7,778
                          
                          
                          
                          -
                          
                          
                          
                          7,778Other real estate owned
                          
                          
                          -
                          
                          
                          
                          2,607
                          
                          
                          
                          -
                          
                          
                          
                          2,607Total assets measured on a non-recurring
      basis
                          
                          $
                          -
                          
                          
                          $
                          49,520
                          
                          
                          $
                          -
                          
                          
                          $
                          49,520
 
 Heritage
Oaks Bancorp | - 19 -


Notes to
Consolidated Financial Statements
 In
addition to the assets presented in the table above, the Company uses fair value
measurements on a non-recurring basis in its assessment of assets classified as
Goodwill.  These assets are recorded at fair value initially and
assessed for impairment periodically thereafter under the provisions set forth
in U.S. GAAP.  During the fiscal year ended December 31, 2008, the
carrying amount of goodwill assets were compared to their fair
value.  No change in carrying amount resulted in accordance with the
provisions 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
8.  Fair Value of Financial Instruments
 
 The fair
value of a financial instrument is the amount at which the asset or obligation
could be exchanged in a current transaction between willing parties, other than
a forced or liquidation sale.  Fair value estimates are made at a
specific point in time based on relevant market information and information
about the financial instrument.  These estimates do not reflect any
premium or discount that could result from offering for sale at one time the
entire holdings or a particular financial instrument.  Because no
market value exists for a significant portion of the financial instruments, fair
value estimates are based on judgments regarding future expected loss
experience, current economic conditions, risk characteristics of various
financial instruments, and other factors.  These estimates are
subjective in nature, involve uncertainties and matters of judgment and,
therefore, cannot be determined with precision.  Changes in
assumptions could significantly affect these estimates.
 
 Fair
value estimates are based on financial instruments both on and off the balance
sheet without attempting to estimate the value of anticipated future business
and the value of assets and liabilities that are not considered financial
instruments.  Additionally, tax consequences related to the
realization of the unrealized gains and losses can have a potential effect on
fair value estimates and have not been considered in many of the
estimates.
 
 The
following table provides a summary of the estimated fair value of financial
instruments at September 30, 2009:
 
 September 30, 2009Carrying(dollars in thousands)
                      
                      Amount
                      
                      
                      Fair ValueAssetsCash
      and cash equivalents
                      
                      $
                      63,895
                      
                      
                      $
                      63,895Interest
      bearing deposits
                      
                      
                      119
                      
                      
                      
                      119Investments
      and mortgage-backed securities
                      
                      
                      102,871
                      
                      
                      
                      102,871Federal
      Home Loan Bank and Federal Reserve Bank stock
                      
                      
                      5,828
                      
                      
                      
                      5,828Loans
      receivable, net of deferred fees and costs
                      
                      
                      708,232
                      
                      
                      
                      714,772Loans
      held for sale
                      
                      
                      7,778
                      
                      
                      
                      7,778Bank
      owned life insurance
                      
                      
                      11,432
                      
                      
                      
                      11,432Accrued
      interest receivable
                      
                      
                      3,404
                      
                      
                      
                      3,404LiabilitiesNon-interest
      bearing deposits
                      
                      
                      181,670
                      
                      
                      
                      181,670Interest
      bearing deposits
                      
                      
                      571,859
                      
                      
                      
                      569,138Federal
      Home Loan Bank advances
                      
                      
                      65,000
                      
                      
                      
                      65,230Junior
      subordinated debentures
                      
                      
                      13,403
                      
                      
                      
                      12,331Accrued
      interest payable
                      
                      
                      606
                      
                      
                      
                      606
 
 Notional
                        
                        
                        Cost to CedeAmount
                        
                        
                        or AssumeOff-balance
      sheet instruments, commitments to extend creditand
      standby letters of credit
                        
                        $
                        203,596
                        
                        
                        $
                        2,036
 
 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.
 
 | -
20 -
  
  Notes to
Consolidated Financial Statements
  Interest
Bearing Deposits and Accrued Interest Payable
 
 The fair
values disclosed for interest bearing deposits (for example, interest-bearing
checking accounts and passbook accounts) are, by definition, equal to the amount
payable on demand at the reporting date (that is, their carrying
amounts).  The fair values for certificates of deposit are estimated
using a discounted cash flow analysis that applies interest rates currently
being offered on certificates to a schedule of aggregated contractual maturities
on such time deposits.
 
 The
carrying amount of accrued interest payable approximates its fair
value.
 
 Investments
Including Federal Home Loan Bank Stock, Federal Reserve Bank Stock and
Mortgage-Backed Securities
 
 Fair
values are based upon quoted market prices, where available. If quoted market
prices are not available, fair values are extrapolated from the quoted prices of
similar instruments or through the use of other observable data supporting a
valuation model.  Fair values for holdings of Federal Home Loan Bank
and Federal Reserve Bank stock are based on carrying amounts.
 
 Loans,
Loans Held for Sale, and Accrued Interest Receivable
 
 For
variable-rate loans that re-price frequently and with no significant change in
credit risk, fair values are based on carrying amounts.  The fair
values for other loans (for example, fixed rate commercial real estate and
rental property mortgage loans and commercial and industrial loans) are
estimated using discounted cash flow analysis, based on interest rates currently
being offered for loans with similar terms to borrowers of similar credit
quality.  Loan fair value estimates include judgments regarding future
expected loss experience and risk characteristics.
 
 The fair
value of loans held for sale is determined, when possible, using quoted
secondary market prices.  If no such quoted price exists, the fair
value of the loan is determined using quoted prices for a similar asset or
assets, adjusted for the specific attributes of that loan.
 
 The
carrying amount of accrued interest receivable approximates its fair
value.
 
 Bank
Owned Life Insurance
 
 Fair
values are based on current cash surrender values at each reporting date
provided by the underlying insurers.
 
 Federal
Home Loan Bank Advances
 
 The fair
value disclosed for FHLB advances is determined by discounting contractual cash
flows at current market interest rates for similar instruments.
 
 Junior
Subordinated Debentures
 
 The fair
value disclosed for junior subordinated debentures is based on contractual cash
flows at current market interest rates for similar instruments.
 
 Off-Balance
Sheet Instruments
 
 Fair
values of commitments to extend credit and standby letters of credit are based
upon fees currently charged to enter into similar agreements, taking into
account the remaining terms of the agreement and the counterparties' credit
standing.
  | -
21 -
  
  Notes to
Consolidated Financial Statements
  Note
9.  Preferred Stock
 
 On
February 27, 2009, the Company received shareholder approval for an amendment of
its Articles of Incorporation to add a class of preferred stock, which
ultimately allowed it to participate in the U.S Treasury’s Capital Purchase
Program (“CPP”).
 
 Under its
Amended Articles of Incorporation, The Company is authorized to issue up to
5,000,000 shares of preferred stock, in one or more series, having such voting
powers, designations, preferences, rights, qualifications, limitations and
restrictions as determined by the Board of Directors.
 
 On March
20, 2009, the Company issued 21,000 shares of Senior Preferred Stock to the U.S.
Treasury under the terms of the CPP for $21.0 million with a liquidation
preference of $1,000 per share.  The preferred stock will carry a
coupon of 5% for five years and 9% thereafter.  Senior preferred
issued to the U.S. Treasury will be non-voting, cumulative, and perpetual and
may be redeemed at 100% of their liquidation preference plus accrued and unpaid
dividends following three years from the date of issue.  In addition,
the Company issued a warrant to the U.S. treasury to purchase shares of the
Company’s common stock in an amount equal to 15% of the preferred equity
issuance or approximately $3.2 million (611,650 shares).  The warrant
is exercisable immediately at a price of $5.15 per share, will expire after a
period of 10 years from issuance and is transferable by the U.S.
Treasury.  The Company expects the warrant to be dilutive to earnings
per common share.
 
 The U.S.
Treasury may not transfer a portion or portions of the warrant with respect to,
and/or exercise the warrant for more than one-half of, the 611,650 common shares
issuable upon exercise of the warrant, in the aggregate, until the earlier of
(i) the date on which the Company has received aggregate gross proceeds of
not less than $21.0 million from one or more Qualified Equity Offerings and
(ii) December 31, 2009.  However, if the Company were to redeem all of
the Senior Preferred Stock as permitted by and in accordance with the provisions
set forth under the CPP, the U.S. Treasury will be permitted, subject to
compliance with applicable securities laws, to transfer all or a portion of the
warrant with respect to, and/or exercise the warrant for, all or a portion of
the number of common shares issuable thereunder, at any time and without
limitation.  In the event the Company completes one or more Qualified
Equity Offerings on or prior to December 31, 2009, that result in the
Company receiving aggregate gross proceeds of not less than $21.0 million, the
number of the common shares underlying the portion of the warrant then held by
the U.S. Treasury will be reduced by one-half of the common shares originally
covered by the warrant.  The U.S. Treasury has agreed not to exercise
voting power with respect to any common shares issued to it upon exercise of the
warrant.   At September 30, 2009, there had been no changes to
the number of common shares covered by the warrant nor had the U.S. Treasury
exercised any portion of the warrant.
 
 The
proceeds received from the U.S. Treasury were allocated to the Senior Preferred
Stock and the warrant based on their relative fair values.  The fair
value of the Senior Preferred Stock was determined through a discounted future
cash flow model at a discount rate of 10%.  The fair value of the
warrant was calculated using the Black-Scholes option pricing model, which
includes assumptions regarding the Company’s dividend yield, stock price
volatility, and the risk-free interest rate.  As a result the Company
recorded the Senior Preferred Stock and the warrant at approximately $19.2
million and $1.8 million, respectively.  The Company will accrete the
discount on the Senior Preferred Stock over a period of five years with
corresponding charges to retained earnings.
 
 It is
also important to note that net income available to common shareholders will be
impacted to the extent the Company charges retained earnings for the accretion
of the discount on the Senior Preferred Stock and any dividends paid from
retained earnings on the Senior Preferred Stock.  For the three and
nine month periods ended September 30, 2009, dividends and accretion on the
Senior Preferred Stock totaled approximately $352 thousand and $613 thousand,
respectively.
 
 Additionally,
the Company is subject to certain limitations during its participation in the
CPP including:
 
 ·
              The
      requirement to obtain consent from the U.S. Treasury for any proposed
      increases in common stock dividends prior to the third anniversary date of
      the preferred equity issuance.
 
 ·
              The
      Senior Preferred Stock cannot be redeemed for three years unless the
      Company obtains proceeds to replace the Senior Preferred Stock through a
      qualified equity offering.
 
 ·
              The
      U.S. Treasury must consent to any buy back of our common
      stock.
 
 ·
              The
      Company must adhere to restrictions placed on the amount of and type of
      compensation paid to its executives while participating in the CPP,
      pursuant to section 111 of the Emergency Economic Stabilization Act of
      2008, as amended (“EESA”).
  | -
22 -
  
  Notes to
Consolidated Financial Statements
  Note
10.  Subsequent Events
 
 Late in
October 2009, the Bank received approximately $0.8 million in proceeds from one
customer related to interest the Bank previously accrued but that was reversed
as a result of placing the loan on non-accrual status during the third quarter
of 2009.  As a result of the customer’s payment, the Bank moved the
loan back to performing status during the month of October and will recognize
approximately $0.8 million in interest income in the fourth quarter of 2009
related to this loan.  The balance of the loan at September 30, 2009
was approximately $10.7 million.  The loan was originally placed on
non-accrual as a result of an issue related to the treatment of an interest
reserve.
 
 The FDIC
recently completed its regularly scheduled examination of the
Bank.  Based on discussions with the FDIC following the examination,
it is expected that the Bank will receive a formal agreement or enforcement
order from the FDIC requiring the Bank to take certain steps to further
strengthen the Bank, such as reducing the level of classified assets, increasing
capital levels, and addressing other criticisms from the
examination.  Management is already developing strategies and taking
actions to address such issues.
 
 The Bank
is presently awaiting updated appraisals of real property securing a significant
portion of classified loans, which we expect to receive in the fourth quarter of
2009.  The result of these appraisals either positive or negative may
have an impact on the required level of the allowance for loan losses in the
fourth quarter of 2009.  If the results of these appraisals indicate
that the value of the properties securing these loans has declined since the
date of the last appraisal, the Bank may be required to make additional
provisions for loan losses in the fourth quarter of 2009.
 
 Note
11.  Reclassifications
 
 Certain
amounts in the 2008 financial statements have been reclassified to conform to
the 2009 presentation.  | -
23 -
  
  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, the recent fluctuations in U.S.
markets resulting, in part, from problems related to sub-prime lending, the
recent downturn in the California real estate market, general economic and
business conditions in those areas in which the Company operates, demographic
changes, competition, fluctuations in interest rates, changes in business
strategy or development plans, changes in governmental regulation, credit
quality, the availability of capital to fund the expansion of the Company’s
business, as well as economic, political and global changes arising from the war
on terrorism, increased profitability, continued growth, the Bank’s beliefs as
to the adequacy of its existing and anticipated allowance for loan losses,
beliefs and expectations regarding actions that may be 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, 2008 10-K, ITEM
1A. Risk Factors). The Company disclaims any obligation to update any such
factors or to publicly announce the results of any revisions to any of the
forward-looking statements contained herein to reflect future events or
developments.  Heritage Oaks Bancorp | - 24
-
  
  Item
2.  Management’s Discussion and Analysis of Financial Condition and
Results of Operations
 
 The
following is an analysis of the results of operations and financial condition of
the Company as of and for the three and nine month periods ending September 30,
2009 and 2008.  The analysis should be read in connection with the
consolidated financial statements and notes thereto appearing elsewhere in this
report.
 
 The
Company
 
 Heritage
Oaks Bancorp (the "Company") is a California corporation organized in 1994 to
act as a holding company of Heritage Oaks Bank ("Bank"), a 15 branch bank
serving San Luis Obispo and Santa Barbara Counties.  In 1994, the
Company acquired all of the outstanding common stock of the Bank in a holding
company formation transaction.
 
 In
October 2006, the Company formed Heritage Oaks Capital Trust II (“Trust II”).
Trust II is a statutory business trust formed under the laws of the State of
Delaware and is a wholly-owned, non-financial, non-consolidated subsidiary of
the Company.
 
 In
September 2007, the Company formed Heritage Oaks Capital Trust III (“Trust
III”). Trust III is a statutory business trust formed under the laws of the
State of Delaware and is a wholly-owned, non-financial, non-consolidated
subsidiary of the Company.
 
 On
October 12, 2007, the Company acquired Business First National Bank (“Business
First”).  Business First was merged with and into Heritage Oaks Bank,
a wholly owned subsidiary of the Company.  In connection with the
acquisition, two additional branches were added to the Bank’s
network.  For additional information regarding this acquisition,
please see Note 23 to the consolidated financial statements of the Company’s
2008 annual report, which was filed on Form 10-K.
 
 Other
than holding the shares of the Bank, the Company conducts no significant
activities, although it is authorized, with the prior approval of the Board of
Governors of the Federal Reserve System (the "Federal Reserve Board"), the
Company's principal regulator, to engage in a variety of activities which are
deemed closely related to the business of banking. The Company has also caused
to be incorporated a subsidiary, CCMS Systems, Inc. which is currently inactive
and has not been capitalized. The Company has no present plans to activate the
proposed subsidiary.
 
 Where
You Can Find More Information
 
 Under the
Securities Exchange Act of 1934 Sections 13 and 15(d), periodic and current
reports must be filed with the SEC. The Company electronically files the
following reports with the SEC: Form 10-K (Annual Report), Form 10-Q (Quarterly
Report), Form 8-K (Current Report), and Form DEF 14A (Proxy Statement). The
Company may file additional forms. The SEC maintains an internet site,
www.sec.gov, in which all forms filed electronically may be accessed.
Additionally, all forms filed with the SEC and additional shareholder
information is available free of charge on the Company’s website:
www.heritageoaksbancorp.com.
 
 The
Company posts these reports to its website as soon as reasonably practicable
after filing them with the SEC.  None of the information on or
hyperlinked from the Company’s website is incorporated into this Quarterly
Report on Form 10-Q.   | -
25 -
  
 Management’s
Discussion and Analysis
 Executive
Summary
 
 For the
three and nine month periods ended September 30, 2009, net losses available to
common shareholders were approximately $5.6 million and $4.2 million,
respectively.  In the same periods ended a year earlier, the Company
reported net income available to common shareholders of approximately $0.5
million and $2.9 million, respectively.  Losses per diluted common
share were ($0.73) and ($0.56) for the three and nine months ended September 30,
2009.  The Company reported earnings per diluted common share of $0.07
and $0.37 for the same three and nine month periods ended a year
earlier.  Several significant factors that contributed substantially
to the year over year decline in earnings were: elevated provisions for loan
losses, losses incurred from the write-down and sale of certain OREO properties,
increases in regulatory assessments costs, the one-time assessment imposed by
the FDIC on all insured institutions, interest reversals related to loans placed
on non-accrual status, as well as the absence of income in the amount of $0.3
million the Bank recognized related to the Visa, Inc. IPO during the second
quarter of 2008.
 
 Provisions
for loan losses during the three and nine months ended September 30, 2009 were
approximately $9.8 million and $14.6 million, respectively.  When
compared to the $3.2 million and $6.2 million reported for the same periods
ended a year earlier, this represents respective increases of approximately $6.6
million and $8.4 million.  Elevated provisions for loan losses during
2009 are the primary factor behind the year over year decline in
earnings.  See also “Provision for Loan Losses” of this Discussion and
Analysis for more information regarding factors impacting the level of provision
for loan losses during 2009.
 
 During
the third quarter of 2009 the Bank wrote down the value of one foreclosed
property in the amount of $1.3 million.  This property represents land
for commercial development and is located within the Bank’s primary market
area.  Additionally, the Bank sold five properties during the third
quarter and recognized aggregate losses in connection with those sales of
approximately $0.2 million.
 
 Contributing
further to the year over year decline in earnings were increased regulatory
assessment costs, resulting from a one-time special assessment imposed by the
FDIC on all insured institutions that totaled approximately $0.4 million for the
Bank and was booked during the second quarter.  Year over year
increases within this category can also be attributed to a one-time charge in
the approximate amount of $0.5 million to correct for the cumulative effect of
an error related to the accrual of FDIC assessments from 2007 through June 30,
2009.  Management determined that the amounts were not material to the
Company’s financial condition and results of operations in each reporting period
from 2007 through June 30, 2009, and as a result processed the correcting entry
in the third quarter of 2009.
 
 The
following provides a summary of operating results for the three and nine month
periods ended September 30, 2009 and 2008:
 
 ·
              For
      the three and nine months ended September 30, 2009 interest income totaled
      approximately $11.9 million and $36.0 million,
      respectively.  This when compared to the same three and nine
      month periods ended a year earlier, represents declines of approximately
      $0.7 million and $1.9 million, respectively.  Although, floors
      within the loan portfolio were instrumental in abating any substantial
      year over year decline in interest income, interest reversals related to
      loans placed on non-accrual during the first nine months of the year
      negatively impacted this line item.  Contributing significantly
      to the amount of interest reversed during the third quarter, was the
      reversal of approximately $0.8 million in interest income related to one
      loan placed on non-accrual, the result of an issue related to the
      treatment of an interest reserve.  As disclosed in Note 10.
      Subsequent Events of the consolidated financial statements, upon working
      with the borrower the Bank was able to recover the uncollected interest
      in  October 2009 and subsequently moved the loan back to
      performing status.  For the three and nine months ended
      September 30, 2009, interest reversals totaled approximately $1.1 million
      and $1.2 million, respectively.
 
 ·
              For
      the three and nine months ended September 30, 2009, interest expense
      totaled approximately $2.6 million and $7.4 million,
      respectively.  When compared to the same periods ended a year
      earlier, interest expense declined approximately $0.4 million and $2.3
      million, respectively.  Although core deposit balances increased
      significantly when compared to that reported a year earlier, declines in
      the overnight Fed Funds rate during the later part of 2008 helped to bring
      down the cost of deposits and borrowings for the Bank, contributing
      substantially to the year over year decline in interest
      expense.  Additionally, throughout 2008 and early 2009, the Bank
      stayed relatively short with respect to maturities on various interest
      bearing liabilities, allowing the Bank the opportunity to more rapidly
      re-price those funds in a declining interest rate environment,
      further contributing to the decline in interest
  expense.
 
 ·
              Net
      interest income for the three and nine months ended September 30, 2009
      totaled approximately $9.3 million and $28.7 million,
      respectively.  Net interest income declined approximately $0.3
      million from that reported during the same three month period ended a year
      earlier and increased approximately $0.4 million when compared to same
      nine month period ended a year ago.  Year over year changes in
      net interest income can be attributed in large part to the items mentioned
      in the preceding paragraphs.
  
 | - 26 -
  
 Management’s
Discussion and Analysis
 
 ·
              Non-interest
      income totaled approximately $1.6 million and $4.8 million for the three
      and nine month periods ended September 30, 2009, representing respective
      increases of approximately $80 thousand and $45 thousand when compared to
      the same periods ended a year earlier.  The modest year over
      year increases within this category can be attributed to increases in
      mortgage origination fee income of approximately $0.1 million and $0.5
      million for the three and nine month periods ended September 30, 2009,
      respectively.  Additionally, gains on the sale of securities and
      SBA loans in the aggregate amounts of $0.3 million and $0.4 million for
      the three and nine months ended September 30, 2009, respectively
      contributed further to the increase within this
      category.  Offsetting these increases were year over year
      declines in service charge fee income of approximately $0.1 million and
      $0.3 million for the quarter and year to date periods ended September 30,
      2009.  For more information related to non-interest income,
      please see “Non-Interest Income” of this Discussion and
      Analysis.
 
 ·
              Non-interest
      expense for the third quarter and the first nine months of 2009 totaled
      approximately $10.3 million and $25.7 million,
      respectively.  Non-interest expense increased approximately $3.1
      million during the third quarter and $3.5 million for the first nine
      months of 2009, respectively when compared to the same periods ended a
      year earlier.  The primary factor behind the year over year
      increases within this category can be attributed to the write-down of one
      OREO property in the third quarter of 2009, totaling approximately $1.3
      million.  For the third quarter and the first nine months of
      2009, OREO write-downs totaled approximately $1.4 million and $1.5
      million, respectively.  OREO write-downs accounted for
      approximately 44.0% and 42.3% of the increase in non-interest expenses for
      the three and nine month periods ended September 30,
      2009.  Further contributing to the increase in non-interest
      expenses was an increase in regulatory assessment costs, the Special
      Assessment imposed by the FDIC on
      all insured institutions during the second quarter of 2009 and
      a one-time charge related to the cumulative effect of an error related to
      the accrual of FDIC assessments from 2007 through June 30, 2009,
      previously mentioned.  For more information related to
      non-interest expenses, please see “Non-Interest Expenses” of this
      Discussion and Analysis.
 
 ·
              For
      the three and nine months ended September 30, 2009, the Company’s
      efficiency ratio was 95.12% and 77.02%, respectively.  This
      compares to 64.40% and 67.55% reported for the same periods ended a year
      earlier.  The efficiency ratio was negatively impacted during
      the third quarter and the first nine months of 2009 by several one-time
      charges previously mentioned and that include: increased regulatory
      assessment costs, expenses and write-downs related to OREO properties, and
      a one-time charge related to the cumulative effect of an accounting error
      related to the accrual of FDIC assessment
      premiums.  Additionally, the reversal of approximately $1.1
      million and $1.2 million in accrued interest related to loans the Bank
      placed on non-accrual during the three and nine months ended September 30,
      2009 contributed to the rise in the efficiency ratio.  As
      previously mentioned, interest reversals include approximately $0.8
      million related to one loan placed on non-accrual during the third quarter
      of 2009.  In October 2009, the Bank recovered all previously
      accrued interest on this loan and returned the loan to performing
      status.  Exclusive of one-time charges and the reversal of $0.8
      million in interest income related to the loan previously mentioned, the
      efficiency ratio for the three and nine month periods ended September 30,
      2009 was 68.44% and 66.28%, respectively.  Management remains
      focused on cost controls in an effort to mitigate the rise in non-interest
      expenses brought on by the one-time charges previously
      discussed.
 
 The
following provides a summary for significant year to date changes in balances as
of September 30, 2009:
 
 ·
              At
      September 30, 2009, net loan balances were approximately $692.4 million or
      approximately $24.4 million and 3.6% higher than the $668.0 million
      reported at December 31, 2008.  See also “Loans” under
      “Financial Condition” of this Discussion and Analysis for additional
      information regarding the Bank’s loan
portfolio.
 
 ·
              At
      September 30, 2009, total deposits were approximately $753.5 million or
      approximately $150.0 million and 24.9% higher than the $603.5 million
      reported at December 31, 2008.  Deposits, exclusive of brokered
      were approximately $736.5 million or $181.6 million higher than the $554.9
      million reported at December 31, 2008.  See also “Deposits and
      Borrowed Funds” under “Financial Condition” of this Discussion and
      Analysis for information regarding the Bank’s deposit
      liabilities.
 
 ·
              At
      September 30, 2009, borrowings with the FHLB were $65.0 million or
      approximately $44.0 million lower than the $109.0 million reported at
      December 31, 2008.  Higher retail deposit balances during the
      first nine months of 2009 resulted in fewer borrowings with the
      FHLB.
  
 | - 27 -
  
  Management’s
Discussion and Analysis
 
 ·
              Investment
      securities totaled approximately $102.9 million or approximately $52.1
      million higher than the $50.8 million reported at December 31,
      2008.  The year to date increase in the portfolio can be
      attributed to purchases the Bank made to take advantage of increased
      credit spreads available on investment securities and to invest excess
      liquidity in cash flow generating instruments in the absence of 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.  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 totaled approximately $45.7 million at September 30, 2009,
      representing an increase of approximately $39.1 million over that reported
      at December 31, 2008.  Increased balances within this category
      can be attributed to increased core deposit balances throughout
      2009.  See also “Investment Securities and Other Earning Assets”
      of this Discussion and Analysis for additional information regarding
      Federal Funds sold.
 
 The
following provides an overview of asset quality as of September 30,
2009:
 
 ·
              At
      September 30, 2009, the balance of non-performing loans was approximately
      $39.8 million or $21.1 million higher than the $18.7 million reported at
      December 31, 2008.  As of September 30, 2009 the balance of
      non-performing loans as a percentage of total gross loans was 5.61%
      compared to 2.75% as of December 31, 2008.  During the third
      quarter of 2009, the Bank added approximately $34.2 million in loan
      balances to non-accruing status.  Contributing to the increase
      in non-accruing balances was the addition of one loan in the approximate
      amount of $10.7 million.  As mentioned, upon working with the
      borrower, Management was able to recover the interest reversed during the
      third quarter and move the loan back to performing status during the month
      of October 2009.   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.
 
 ·
              As
      of September 30, 2009, the allowance for loan losses totaled approximately
      $15.9 million, representing 2.24% of total gross loans.  This
      compares to the $10.4 million or 1.53% of total gross loans reported at
      December 31, 2008.  Provisions for loan losses during the three
      and nine month periods ended September 30, 2009 totaled approximately $9.8
      million and $14.6 million, respectively.  See also “Provision
      for Loan Losses” of this Discussion and Analysis for a more complete
      discussion regarding loan loss
provisions.
 
 ·
              Charge-offs
      during the three and nine month periods ended September 30, 2009 were
      approximately $5.0 million and $9.1 million, respectively.  For
      the three and nine months ended September 30, 2009 net charge-offs to
      average gross loans were 0.70% and 1.29%, respectively.  When
      compared to the 0.15% and 0.31% reported for the same periods ended a year
      earlier, represents increases 55 and 98 basis points,
      respectively.
 
 ·
              During
      the first nine months of 2009, the Bank moved approximately $9.7 million
      in loan balances to foreclosed status of which approximately $9.6 million
      was classified as OREO.  During the third quarter of 2009
      balances that moved to OREO totaled approximately $1.2
      million.  As of September 30, 2009, the balance of OREO was $2.6
      million compared to the $1.3 million reported at December 31,
      2008.  In spite of the year to date increase in OREO balances,
      the Bank sold five properties during the third quarter, previously booked
      at $3.9 million.  Aggregate net losses the Bank incurred related
      to these sales totaled approximately $0.2 million.  For the
      first nine months of 2009, the Bank incurred aggregate net losses of
      approximately $0.3 million related to the sale of OREO
      properties.  See also “Non Performing Assets” under “Financial
      Condition” of this Discussion Analysis for additional information related
      asset quality.
 
 Recent
Developments
 
 During
the third and fourth quarters of 2008, the credit and equity markets came under
significant duress as confidence by many in the U.S. financial system began to
wane.  During the later part of 2007 and throughout 2008, many U.S.
financial institutions were forced to significantly write-down the values of
certain classes of assets in response to the weakened real estate
market.  These losses lead to strained capital levels, impairing the
confidence of many depositors and others providing funding to the nation’s
banks, which in turn lead to a crisis of liquidity.  With liquidity
levels of many financial institutions significantly weakened, borrowing costs
began to rise considerably and the flow of credit to consumers and between banks
all but came to a halt.  In response to this, the weakened economy and
other factors, the U.S. Congress passes the Emergency Economic Stabilization Act
of 2008 (the “EESA”) in October of 2008.  Under the EESA, the
Department of the U.S. Treasury formed the Troubled Asset Relief Program (the
“TARP”).  The TARP gives the U.S. Treasury the power to make purchases
of certain troubled assets as well as the direct purchase of equity from U.S.
financial institutions under the CPP.  Although the Company’s
liquidity levels remained adequate and the Bank and Company were well
capitalized throughout 2008, the Company applied to participate in the CPP to
keep all capital raising options available.  On February 27, 2009, the
Company received shareholder approval to add an authorized class of preferred
stock to the Company’s Articles of Incorporation that allowed the Company to
participate in the CPP and will also allow for more flexibility in capital
raising efforts in general.  On March 20, 2009, the Company issued
21,000 shares of Senior Preferred Stock to the U.S. Treasury under the terms of
the CPP for $21.0 million.  Additionally, the Company issued a warrant
to the U.S. Treasury to purchase 611,650 shares of its common stock at a price
of $5.15 per share, representing 15% of the preferred issuance or approximately
$3.2 million.  For a more detailed discussion regarding the Company’s
participation in the CPP, see Note 9. Preferred Stock, to the consolidated
financial statements filed on this Form 10-Q.
  
 | - 28 -
  
 Management’s
Discussion and Analysis
 Dividends
and Stock Repurchases
 
 During
the first nine month of 2009, the Company paid approximately $424 thousand in
dividends on its Senior Preferred Stock issued to the U.S. Treasury under the
CPP.  The Company paid dividends of approximately $263 thousand on its
Senior Preferred Stock during the third quarter of 2009.  See also
Note 9. Preferred Stock, to the consolidated financial statements filed on this
form 10-Q for additional information about dividends on the Company’s Senior
Preferred Stock.
 
 On April
24, 2008, the Board of Directors declared a 5% stock divided to be paid on May
16, 2008 to shareholders of record on May 2, 2008.  This stock
dividend represented a change in the form of dividend payment to the Company’s
shareholders away from cash dividends in order to retain the Company’s capital
for future growth.
 
 On
January 24, 2008, the Board of Directors declared a quarterly cash dividend of
$0.08 per share to be paid on February 15, 2008 to shareholders of record on
February 1, 2008.
 
 The
Company paid no dividends on or made repurchases of its common stock during the
three and nine months ended September 30, 2009.
 
 Selected
Financial Data
 
 The table
below provides selected financial data that highlights the Company’s quarterly
performance results:
 
 For the quarters ended,(dollars in thousands except per share data)
                      
                      09/30/09
                      
                      
                      06/30/09
                      
                      
                      03/31/09
                      
                      
                      12/31/08
                      
                      
                      09/30/08
                      
                      
                      06/30/08
                      
                      
                      03/31/08
                      
                      
                      12/31/07Return
      on average assets
                      
                      
                      -2.30
                      %
                      
                      
                      0.23
                      %
                      
                      
                      0.54
                      %
                      
                      
                      -0.63
                      %
                      
                      
                      0.27
                      %
                      
                      
                      0.35
                      %
                      
                      
                      0.91
                      %
                      
                      
                      1.11
                      %Return
      on average equity
                      
                      
                      -22.54
                      %
                      
                      
                      2.20
                      %
                      
                      
                      6.04
                      %
                      
                      
                      -6.93
                      %
                      
                      
                      2.94
                      %
                      
                      
                      3.84
                      %
                      
                      
                      9.55
                      %
                      
                      
                      11.65
                      %Return
      on average common equity
                      
                      
                      -30.41
                      %
                      
                      
                      1.41
                      %
                      
                      
                      6.19
                      %
                      
                      
                      -6.93
                      %
                      
                      
                      2.94
                      %
                      
                      
                      3.84
                      %
                      
                      
                      9.55
                      %
                      
                      
                      11.65
                      %Average
      equity to average assets
                      
                      
                      10.18
                      %
                      
                      
                      10.68
                      %
                      
                      
                      8.95
                      %
                      
                      
                      9.06
                      %
                      
                      
                      9.16
                      %
                      
                      
                      9.14
                      %
                      
                      
                      9.48
                      %
                      
                      
                      9.49
                      %Average
      common equity to average assets
                      
                      
                      8.06
                      %
                      
                      
                      8.47
                      %
                      
                      
                      8.64
                      %
                      
                      
                      9.06
                      %
                      
                      
                      9.16
                      %
                      
                      
                      9.14
                      %
                      
                      
                      9.48
                      %
                      
                      
                      9.49
                      %Net
      interest margin
                      
                      
                      4.34
                      %
                      
                      
                      4.91
                      %
                      
                      
                      5.03
                      %
                      
                      
                      5.04
                      %
                      
                      
                      5.18
                      %
                      
                      
                      5.28
                      %
                      
                      
                      5.33
                      %
                      
                      
                      5.33
                      %Efficiency
      ratio*
                      
                      
                      95.12
                      %
                      
                      
                      70.02
                      %
                      
                      
                      66.71
                      %
                      
                      
                      66.43
                      %
                      
                      
                      64.40
                      %
                      
                      
                      66.31
                      %
                      
                      
                      72.17
                      %
                      
                      
                      67.26
                      %Average
      loans to average deposits
                      
                      
                      98.20
                      %
                      
                      
                      103.58
                      %
                      
                      
                      112.39
                      %
                      
                      
                      109.95
                      %
                      
                      
                      111.54
                      %
                      
                      
                      109.26
                      %
                      
                      
                      103.64
                      %
                      
                      
                      96.40
                      %Net
      (loss) / income
                      
                      $
                      (5,242
                      )
                      
                      $
                      507
                      
                      
                      $
                      1,102
                      
                      
                      $
                      (1,254
                      )
                      
                      $
                      534
                      
                      
                      $
                      691
                      
                      
                      $
                      1,675
                      
                      
                      $
                      1,978Net
      (loss) / income available to common shareholders
                      
                      $
                      (5,594
                      )
                      
                      $
                      257
                      
                      
                      $
                      1,091
                      
                      
                      $
                      (1,254
                      )
                      
                      $
                      534
                      
                      
                      $
                      691
                      
                      
                      $
                      1,675
                      
                      
                      $
                      1,978(Loss)
      / Earnings Per Common Share:Basic
                      
                      $
                      (0.73
                      )
                      
                      $
                      0.03
                      
                      
                      $
                      0.14
                      
                      
                      $
                      (0.16
                      )
                      
                      $
                      0.07
                      
                      
                      $
                      0.09
                      
                      
                      $
                      0.22
                      
                      
                      $
                      0.26Diluted
                      
                      $
                      (0.73
                      )
                      
                      $
                      0.03
                      
                      
                      $
                      0.14
                      
                      
                      $
                      (0.16
                      )
                      
                      $
                      0.07
                      
                      
                      $
                      0.09
                      
                      
                      $
                      0.21
                      
                      
                      $
                      0.25Outstanding
      Shares:Basic
                      
                      
                      7,699,377
                      
                      
                      
                      7,696,027
                      
                      
                      
                      7,689,317
                      
                      
                      
                      7,660,342
                      
                      
                      
                      7,709,600
                      
                      
                      
                      7,705,174
                      
                      
                      
                      7,694,546
                      
                      
                      
                      7,682,730Diluted
                      
                      
                      7,699,377
                      
                      
                      
                      7,866,962
                      
                      
                      
                      7,824,377
                      
                      
                      
                      7,660,342
                      
                      
                      
                      7,798,321
                      
                      
                      
                      7,830,390
                      
                      
                      
                      7,851,831
                      
                      
                      
                      7,887,206
 
 * 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, sale of other real estate owned and
sale of SBA loans.
  
 | - 29 -
  
  Management’s
Discussion and Analysis
  Local
Economy
 
 The
economy in the Company’s service area is based primarily on agriculture,
tourism, light industry, oil and retail trade. Services supporting these
industries have also developed in the areas of medical, financial and
educational services.  The population of San Luis Obispo County, the
City of Santa Maria (in Northern Santa Barbara County), and the City of Santa
Barbara totaled approximately 262,000, 86,000, and 86,000 respectively,
according to the most recent economic data provided by the U.S. Census
Bureau. The moderate climate allows a year round growing season for
numerous vegetables and fruits.  Vineyards and cattle ranches also
contribute largely to the local economy.  The Central Coast’s leading
agricultural industry is the production of wine grapes and production of premium
quality wines. Vineyards in production have grown significantly over the past
several years throughout the Company’s service area.  Access to
numerous recreational activities including lakes, mountains and beaches, provide
a relatively stable tourist industry from many areas including the Los
Angeles/Orange County basin, the San Francisco Bay area and the San Joaquin
Valley. While the economy in the Company’s primary markets of San Luis Obispo
and Santa Barbara counties have not been immune to the negative impacts of both
the national and state economies, the abundant tourism that has developed over
the past decade in our market area, especially in the wine industry and coastal
communities, has helped sustain our local economy in previous economic
downturns.  According to a recent publication by Smith Travel Research
in regard to hotel occupancy rates comparing May 2009 to May 2008, there was a
decline in occupancy of 2.6%, 4.9% and 12.3% for Paso Robles/San Luis Obispo,
Santa Barbara/Santa Maria and the State of California,
respectively.
 
 2009 is
proving to be a challenging year not only on the national level, but within
the state of California and more specifically our primary market
area.  As the U.S. housing market continued to wane throughout 2009
and economic growth continued to slow, 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 crisis
of confidence, further downturn in economic growth and unprecedented volatility
in the U.S. equity and credit markets.  As mentioned, our primary
market area has historically enjoyed a more stable level of economic activity;
however we believe these more macro level concerns have started to become more
evident within our market area.  Recent indications show the
unemployment rate within California to be approximately 12.2%.  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 9.4% and 8.5%, respectively.  Additionally, housing
prices have fallen significantly in California and within the Bank’s market area
from the highs seen during 2007.  Recent indications show that median
home prices within California declined 7.3% from year ago levels and that prices
within the Bank’s primary market of San Luis Obispo and Santa Barbara counties
have actually increased by 3.9% and 17.2%, respectively from depressed levels
seen in 2008.  Even though real estate prices remain well below levels
seen in 2007, sales have been relatively strong within the State of California
and the Company’s primary market area, climbing over 30% compared to 2008, the
majority of which can be attributed to sales of distressed
properties.  That said, the lack of oversupply in the Company’s
market, desirable climate, close proximity to beaches, lakes and the wine
industry, for both San Luis Obispo and Santa Barbara Counties have resulted in
lower percentage declines in prices for the local real-estate market, relative
to other areas of California and have in part resulted in slight year over year
increases in median home prices.
 
 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 Bank 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 2008 Annual
Report, Note 1 of the consolidated financial statements, which was filed on Form
10-K.
 
 The
following is a brief description of the Company’s current accounting policies
involving significant Management valuation judgments.
 
 Loans
and Interest on Loans
 
 Loans
receivable that Management has the intent and ability to hold for the
foreseeable future or until maturity or payoff are reported at their outstanding
unpaid principal balances reduced by any charge-offs of specific valuation
accounts and net of any deferred fees or costs on originated loans, or
unamortized premiums or discounts on purchased loans.   
 | - 30 -
  Management’s
Discussion and Analysis
  Loan
origination fees and certain direct origination costs are capitalized and
recognized as an adjustment in yield of the related loan.
 
 Loans on
which the accrual of interest has been discontinued are designated as
non-accrual loans.  The accrual of interest on loans is discontinued
when principal or interest is past due 90 days based on contractual terms of the
loan or when, in the opinion of Management, there is reasonable doubt as to
collectibility.  When loans are placed on non-accrual status, all
interest previously accrued but not collected is reversed against current period
interest income.  Interest income generally is not recognized on
specific impaired loans unless the likelihood of further loss is
remote.  Interest payments received on such loans are applied as a
reduction to the loan principal balance.  Interest accruals are
resumed on such loans only when they are brought current with respect to
interest and principal and when, in the judgment of Management, the loans are
estimated to be fully collectible as to all principal and interest.
 
 The
Company considers a loan to be impaired when it is probable that the Company
will be unable to collect all amounts due (principal and interest) according to
the contractual terms of the loan agreement.  Measurement of
impairment is based on the expected future cash flows of an impaired loan which
are to be discounted at the loan’s effective interest rate, or measured by
reference to an observable market value, if one exists, or the fair value of the
collateral for a collateral-dependent loan.  The Company selects the
measurement method on a loan-by-loan basis except that collateral-dependent
loans for which foreclosure is probable are measured at the fair value of the
collateral.  The Bank recognizes interest income on impaired loans
based on its existing methods of recognizing interest income on non-accrual
loans.  All loans are generally charged off at such time the loan is
classified as a loss.
 
 Allowance
for Loan Losses
 
 The
allowance for loan losses is maintained at a level which, in Management's
judgment, is adequate to absorb credit losses inherent in the loan
portfolio.  The amount of the allowance is based on Management's
evaluation of the collectibility of the loan portfolio, including the nature and
volume of the portfolio, credit concentrations, trends in historical loss
experience, the level of certain classified balances and specific impaired
loans, and economic conditions and the related impact on specific borrowers and
industry groups.  The allowance is increased by a provision for loan
losses, which is charged to earnings and reduced by charge-offs, net of
recoveries.  Changes in the allowance relating to impaired loans are
charged or credited to the provision for loan losses.  Because of
uncertainties inherent in the estimation process, Management’s estimate of
credit losses inherent in the loan portfolio and the related allowance may
change.
 
 Loans are
considered impaired if, based on current information and events, it is probable
that the Bank will be unable to collect the scheduled payments of principal or
interest when due according to the contractual terms of the loan
agreement.  The measurement of impaired loans is generally based on
the present value of expected future cash flows discounted at the historical
effective interest rate stipulated in the loan agreement, except that all
collateral-dependent loans are measured for impairment based on the fair value
of the collateral.  In measuring the fair value of the collateral,
Management uses assumptions and methodologies consistent with those that would
be utilized by unrelated third parties.  Allowances for impaired loans
are generally determined based on collateral values or the present value of
estimated future 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.
  
 | - 31 -
 
 Management’s
Discussion and Analysis
 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 2008 Annual Report, Note 1 of the consolidated financial
statements, which was filed on Form 10-K, we assess goodwill and other
intangible assets each year for impairment.  The Company’s assessment
at December 31, 2008, pursuant to its Goodwill Impairment Testing Policy, was
performed with the assistance of an independent third party and resulted in no
impairment.
 
 Deferred
Tax Assets
 
 Deferred
income taxes reflect the tax effect of temporary and permanent differences
between the financial statement carrying amount 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.
 
 Results
of Operations
 
 Significantly
impacting the Company’s operating results for the three and nine month periods
ended September 30, 2009 when compared to the same periods ended a year earlier
were considerably higher provisions for loan losses.  Provisions for
loan losses during the three and nine month periods ended September 30, 2009
totaled approximately $9.8 million and $14.6 million,
respectively.  Increases in non-accruing loan balances, loan
charge-offs, 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 2009.  Please see “Provision
for Loan Losses” of this Discussion and Analysis for additional information
related to the year over year increases in provision expenses.
 
 The
Company’s earnings are highly influenced by changes in short term interest
rates.  The nature of the Company’s balance sheet can be summarily
described as of short duration and asset sensitive. The balance sheet is of
short duration because a large percentage of its interest sensitive assets and
liabilities re-price immediately with changes in Federal Funds and Prime
interest rates.  This was evidenced during 2008, as the Federal Open
Market Committee (“FOMC”) cut the overnight Fed Funds rate by over 400 basis
points, placing pressure on the level of and growth in net interest
income.   | -
32 -
  
  Management’s
Discussion and Analysis
  Contributing
significantly to an asset sensitive balance sheet is a relatively large volume
of non-interest bearing demand deposit accounts which effectively never
re-price.  Therefore, an upward movement in short term interest rates
will generally result in higher net interest margin and conversely, a reduction
in short term interest rates will result in reduced net interest
margin.  However, as a result of promotions 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 Fed Funds and Prime rates during
2008.
 
 For the
three and nine months ended September 30, 2009, the net interest margin was
4.34% and 4.75%, respectively.  This compares to the 5.18% and
5.26% reported for the same periods ended in 2008.  The year over year
declines in the net interest margin can be attributed to reductions in the
overnight Fed Funds rate, higher average balances of Federal Funds sold
resulting from substantial increases in core deposit balances and interest
reversals related to the loans placed on non-accrual during 2009.  The
resulting decrease in yield on earning assets overall was the driver in regard
to margin compression during 2009.
 
 Historically,
the largest and most variable source of income for the Company is net interest
income. The results of operations for the three and nine months ended September
30, 2009 and 2008 reflect the impact of dramatically lower interest rates
throughout the majority of 2008 as the result of a significantly weakened
economy.
 
 Net
Interest Income and Margin
 
 Net
interest income, the primary component of the net earnings of a financial
institution, refers to the difference between the interest paid on deposits and
borrowings, and the interest earned on loans and investments.  The net
interest margin is the amount of net interest income expressed as a percentage
of average earning assets. Factors considered in the analysis of net interest
income are the composition and volume of earning assets and interest-bearing
liabilities, the amount of non-interest bearing liabilities and non-accrual
loans, and changes in market interest rates.
  
 | - 33 -
  
  Management’s
Discussion and Analysis
  The
tables below set forth average balance sheet information, interest income and
expense, average yields and rates and net interest income and margin for the
three and nine month periods ended September 30, 2009 and 2008. The average
balance of non-accruing loans has been included in loan totals:
 
 For the three months ending
                                                        
                                                        
                                                        For the three months endingSeptember 30, 2009
                                                        
                                                        
                                                        September 30, 2008Yield/
                                                        
                                                        
                                                        Income/
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        Yield/
                                                        
                                                        
                                                        Income/(dollars in thousands)
                                                        
                                                        Balance
                                                        
                                                        
                                                        Rate (4)
                                                        
                                                        
                                                        Expense
                                                        
                                                        
                                                        Balance
                                                        
                                                        
                                                        Rate (4)
                                                        
                                                        
                                                        ExpenseInterest
      Earning Assets:Investments
      with other banks
                                                        
                                                        $
                                                        119
                                                        
                                                        
                                                        
                                                        3.33
                                                        %
                                                        
                                                        $
                                                        1
                                                        
                                                        
                                                        $
                                                        128
                                                        
                                                        
                                                        
                                                        3.11
                                                        %
                                                        
                                                        $
                                                        1Federal
      funds sold
                                                        
                                                        
                                                        33,895
                                                        
                                                        
                                                        
                                                        0.25
                                                        %
                                                        
                                                        
                                                        21
                                                        
                                                        
                                                        
                                                        3,342
                                                        
                                                        
                                                        
                                                        2.14
                                                        %
                                                        
                                                        
                                                        18Investment
      securities taxable
                                                        
                                                        
                                                        75,563
                                                        
                                                        
                                                        
                                                        4.66
                                                        %
                                                        
                                                        
                                                        888
                                                        
                                                        
                                                        
                                                        43,221
                                                        
                                                        
                                                        
                                                        5.52
                                                        %
                                                        
                                                        
                                                        600Investment
      securities non taxable
                                                        
                                                        
                                                        22,653
                                                        
                                                        
                                                        
                                                        4.33
                                                        %
                                                        
                                                        
                                                        247
                                                        
                                                        
                                                        
                                                        17,125
                                                        
                                                        
                                                        
                                                        4.32
                                                        %
                                                        
                                                        
                                                        186Loans
      (1) (2)
                                                        
                                                        
                                                        713,810
                                                        
                                                        
                                                        
                                                        5.95
                                                        %
                                                        
                                                        
                                                        10,703
                                                        
                                                        
                                                        
                                                        667,441
                                                        
                                                        
                                                        
                                                        6.99
                                                        %
                                                        
                                                        
                                                        11,731Total
      interest earning assets
                                                        
                                                        
                                                        846,040
                                                        
                                                        
                                                        
                                                        5.56
                                                        %
                                                        
                                                        
                                                        11,860
                                                        
                                                        
                                                        
                                                        731,257
                                                        
                                                        
                                                        
                                                        6.82
                                                        %
                                                        
                                                        
                                                        12,536Allowance
      for possible loan losses
                                                        
                                                        
                                                        (11,969
                                                        )
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        (8,664
                                                        )Other
      assets
                                                        
                                                        
                                                        71,976
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        65,230Total
      assets
                                                        
                                                        $
                                                        906,047
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        $
                                                        787,823Interest
      Bearing Liabilities:Interest
      bearing demand
                                                        
                                                        $
                                                        67,825
                                                        
                                                        
                                                        
                                                        0.92
                                                        %
                                                        
                                                        $
                                                        157
                                                        
                                                        
                                                        $
                                                        74,042
                                                        
                                                        
                                                        
                                                        0.47
                                                        %
                                                        
                                                        $
                                                        88Savings
                                                        
                                                        
                                                        25,619
                                                        
                                                        
                                                        
                                                        0.28
                                                        %
                                                        
                                                        
                                                        18
                                                        
                                                        
                                                        
                                                        23,272
                                                        
                                                        
                                                        
                                                        0.43
                                                        %
                                                        
                                                        
                                                        25Money
      market
                                                        
                                                        
                                                        209,634
                                                        
                                                        
                                                        
                                                        1.52
                                                        %
                                                        
                                                        
                                                        804
                                                        
                                                        
                                                        
                                                        175,967
                                                        
                                                        
                                                        
                                                        1.75
                                                        %
                                                        
                                                        
                                                        773Time
      deposits
                                                        
                                                        
                                                        219,253
                                                        
                                                        
                                                        
                                                        2.32
                                                        %
                                                        
                                                        
                                                        1,284
                                                        
                                                        
                                                        
                                                        144,490
                                                        
                                                        
                                                        
                                                        3.06
                                                        %
                                                        
                                                        
                                                        1,111Brokered
      money market funds
                                                        
                                                        
                                                        2,826
                                                        
                                                        
                                                        
                                                        0.70
                                                        %
                                                        
                                                        
                                                        5
                                                        
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        0.00
                                                        %
                                                        
                                                        
                                                        -Brokered
      time deposits
                                                        
                                                        
                                                        23,426
                                                        
                                                        
                                                        
                                                        1.46
                                                        %
                                                        
                                                        
                                                        86
                                                        
                                                        
                                                        
                                                        25,028
                                                        
                                                        
                                                        
                                                        3.35
                                                        %
                                                        
                                                        
                                                        211Total
      interest bearing deposits
                                                        
                                                        
                                                        548,583
                                                        
                                                        
                                                        
                                                        1.70
                                                        %
                                                        
                                                        
                                                        2,354
                                                        
                                                        
                                                        
                                                        442,799
                                                        
                                                        
                                                        
                                                        1.98
                                                        %
                                                        
                                                        
                                                        2,208Federal
      funds purchased
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        0.00
                                                        %
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        4,583
                                                        
                                                        
                                                        
                                                        2.26
                                                        %
                                                        
                                                        
                                                        26Securities
      sold under agreement to repurchase
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        0.00
                                                        %
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        2,327
                                                        
                                                        
                                                        
                                                        1.88
                                                        %
                                                        
                                                        
                                                        11Federal
      Home Loan Bank borrowing
                                                        
                                                        
                                                        65,000
                                                        
                                                        
                                                        
                                                        0.63
                                                        %
                                                        
                                                        
                                                        103
                                                        
                                                        
                                                        
                                                        89,408
                                                        
                                                        
                                                        
                                                        2.59
                                                        %
                                                        
                                                        
                                                        582Junior
      subordinated debentures
                                                        
                                                        
                                                        13,403
                                                        
                                                        
                                                        
                                                        4.08
                                                        %
                                                        
                                                        
                                                        138
                                                        
                                                        
                                                        
                                                        13,403
                                                        
                                                        
                                                        
                                                        5.46
                                                        %
                                                        
                                                        
                                                        184Total
      borrowed funds
                                                        
                                                        
                                                        78,403
                                                        
                                                        
                                                        
                                                        1.22
                                                        %
                                                        
                                                        
                                                        241
                                                        
                                                        
                                                        
                                                        109,721
                                                        
                                                        
                                                        
                                                        2.91
                                                        %
                                                        
                                                        
                                                        803Total
      interest bearing liabilities
                                                        
                                                        
                                                        626,986
                                                        
                                                        
                                                        
                                                        1.64
                                                        %
                                                        
                                                        
                                                        2,595
                                                        
                                                        
                                                        
                                                        552,520
                                                        
                                                        
                                                        
                                                        2.17
                                                        %
                                                        
                                                        
                                                        3,011Non
      interest bearing demand
                                                        
                                                        
                                                        178,293
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        155,582Total
      funding
                                                        
                                                        
                                                        805,279
                                                        
                                                        
                                                        
                                                        1.28
                                                        %
                                                        
                                                        
                                                        2,595
                                                        
                                                        
                                                        
                                                        708,102
                                                        
                                                        
                                                        
                                                        1.69
                                                        %
                                                        
                                                        
                                                        3,011Other
      liabilities
                                                        
                                                        
                                                        8,490
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        7,585Total
      liabilities
                                                        
                                                        $
                                                        813,769
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        $
                                                        715,687Stockholders'
      Equity:Preferred
      stock
                                                        
                                                        $
                                                        19,288
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        $
                                                        -Common
      stock
                                                        
                                                        
                                                        48,695
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        48,456Additional
      paid in capital
                                                        
                                                        
                                                        3,125
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        882Retained
      earnings
                                                        
                                                        
                                                        23,171
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        23,401Valuation
      allowance investments
                                                        
                                                        
                                                        (2,001
                                                        )
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        (603
                                                        )Total
      stockholders' equity
                                                        
                                                        
                                                        92,278
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        72,136Total
      liabilities and stockholders' equity
                                                        
                                                        $
                                                        906,047
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        $
                                                        787,823Net
      interest income
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        $
                                                        9,265
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        $
                                                        9,525Net
      interest margin (3)
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        4.34
                                                        %
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        5.18
                                                        %
 
 (1)
              Nonaccrual
      loans have been included in total
loans.
 (2)
              Loan
      fees of $229 and $285 for the three months ending September 30, 2009 and
      2008, respectively have been included in interest income
      computation.
 (3)
              Net
      interest margin has been calculated by dividing the net interest income by
      total average earning assets.
 (4)
              Yield
      / Rate is annualized using actual number of days in
  period.
  
 | - 34 -
  
 Management’s
Discussion and Analysis
 For the nine months ending
                                                        
                                                        
                                                        For the nine months endingSeptember 30, 2009
                                                        
                                                        
                                                        September 30, 2008Yield/
                                                        
                                                        
                                                        Income/
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        Yield/
                                                        
                                                        
                                                        Income/(dollars in thousands)
                                                        
                                                        Balance
                                                        
                                                        
                                                        Rate (4)
                                                        
                                                        
                                                        Expense
                                                        
                                                        
                                                        Balance
                                                        
                                                        
                                                        Rate (4)
                                                        
                                                        
                                                        ExpenseInterest
      Earning Assets:Investments
      with other banks
                                                        
                                                        $
                                                        119
                                                        
                                                        
                                                        
                                                        3.37
                                                        %
                                                        
                                                        $
                                                        3
                                                        
                                                        
                                                        $
                                                        246
                                                        
                                                        
                                                        
                                                        3.80
                                                        %
                                                        
                                                        $
                                                        7Federal
      funds sold
                                                        
                                                        
                                                        22,596
                                                        
                                                        
                                                        
                                                        0.22
                                                        %
                                                        
                                                        
                                                        38
                                                        
                                                        
                                                        
                                                        6,855
                                                        
                                                        
                                                        
                                                        2.53
                                                        %
                                                        
                                                        
                                                        130Investment
      securities taxable
                                                        
                                                        
                                                        59,614
                                                        
                                                        
                                                        
                                                        4.66
                                                        %
                                                        
                                                        
                                                        2,077
                                                        
                                                        
                                                        
                                                        42,656
                                                        
                                                        
                                                        
                                                        5.26
                                                        %
                                                        
                                                        
                                                        1,681Investment
      securities non taxable
                                                        
                                                        
                                                        19,763
                                                        
                                                        
                                                        
                                                        4.34
                                                        %
                                                        
                                                        
                                                        641
                                                        
                                                        
                                                        
                                                        17,223
                                                        
                                                        
                                                        
                                                        4.30
                                                        %
                                                        
                                                        
                                                        555Loans
      (1) (2)
                                                        
                                                        
                                                        705,187
                                                        
                                                        
                                                        
                                                        6.31
                                                        %
                                                        
                                                        
                                                        33,266
                                                        
                                                        
                                                        
                                                        649,511
                                                        
                                                        
                                                        
                                                        7.31
                                                        %
                                                        
                                                        
                                                        35,554Total
      interest earning assets
                                                        
                                                        
                                                        807,279
                                                        
                                                        
                                                        
                                                        5.97
                                                        %
                                                        
                                                        
                                                        36,025
                                                        
                                                        
                                                        
                                                        716,491
                                                        
                                                        
                                                        
                                                        7.07
                                                        %
                                                        
                                                        
                                                        37,927Allowance
      for possible loan losses
                                                        
                                                        
                                                        (10,909
                                                        )
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        (7,120
                                                        )Other
      assets
                                                        
                                                        
                                                        70,288
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        65,028Total
      assets
                                                        
                                                        $
                                                        866,658
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        $
                                                        774,399Interest
      Bearing Liabilities:Interest
      bearing demand
                                                        
                                                        $
                                                        64,524
                                                        
                                                        
                                                        
                                                        0.72
                                                        %
                                                        
                                                        $
                                                        347
                                                        
                                                        
                                                        $
                                                        74,886
                                                        
                                                        
                                                        
                                                        0.61
                                                        %
                                                        
                                                        $
                                                        343Savings
                                                        
                                                        
                                                        23,849
                                                        
                                                        
                                                        
                                                        0.21
                                                        %
                                                        
                                                        
                                                        38
                                                        
                                                        
                                                        
                                                        26,834
                                                        
                                                        
                                                        
                                                        0.95
                                                        %
                                                        
                                                        
                                                        191Money
      market
                                                        
                                                        
                                                        186,921
                                                        
                                                        
                                                        
                                                        1.51
                                                        %
                                                        
                                                        
                                                        2,118
                                                        
                                                        
                                                        
                                                        189,181
                                                        
                                                        
                                                        
                                                        2.03
                                                        %
                                                        
                                                        
                                                        2,878Time
      deposits
                                                        
                                                        
                                                        182,771
                                                        
                                                        
                                                        
                                                        2.49
                                                        %
                                                        
                                                        
                                                        3,400
                                                        
                                                        
                                                        
                                                        142,919
                                                        
                                                        
                                                        
                                                        3.43
                                                        %
                                                        
                                                        
                                                        3,672Brokered
      money market funds
                                                        
                                                        
                                                        25,387
                                                        
                                                        
                                                        
                                                        0.72
                                                        %
                                                        
                                                        
                                                        137
                                                        
                                                        
                                                        
                                                        -
                                                        
                                                        
                                                        
                                                        0.00
                                                        %
                                                        
                                                        
                                                        -Brokered
      time deposits
                                                        
                                                        
                                                        29,886
                                                        
                                                        
                                                        
                                                        1.67
                                                        %
                                                        
                                                        
                                                        373
                                                        
                                                        
                                                        
                                                        15,849
                                                        
                                                        
                                                        
                                                        3.62
                                                        %
                                                        
                                                        
                                                        429Total
      interest bearing deposits
                                                        
                                                        
                                                        513,338
                                                        
                                                        
                                                        
                                                        1.67
                                                        %
                                                        
                                                        
                                                        6,413
                                                        
                                                        
                                                        
                                                        449,669
                                                        
                                                        
                                                        
                                                        2.23
                                                        %
                                                        
                                                        
                                                        7,513Federal
      funds purchased
                                                        
                                                        
                                                        251
                                                        
                                                        
                                                        
                                                        1.07
                                                        %
                                                        
                                                        
                                                        2
                                                        
                                                        
                                                        
                                                        4,079
                                                        
                                                        
                                                        
                                                        2.69
                                                        %
                                                        
                                                        
                                                        82Securities
      sold under agreement to repurchase
                                                        
                                                        
                                                        870
                                                        
                                                        
                                                        
                                                        0.15
                                                        %
                                                        
                                                        
                                                        1
                                                        
                                                        
                                                        
                                                        2,163
                                                        
                                                        
                                                        
                                                        2.35
                                                        %
                                                        
                                                        
                                                        38Federal
      Home Loan Bank borrowing
                                                        
                                                        
                                                        80,982
                                                        
                                                        
                                                        
                                                        0.81
                                                        %
                                                        
                                                        
                                                        492
                                                        
                                                        
                                                        
                                                        74,637
                                                        
                                                        
                                                        
                                                        2.64
                                                        %
                                                        
                                                        
                                                        1,473Junior
      subordinated debentures
                                                        
                                                        
                                                        13,403
                                                        
                                                        
                                                        
                                                        4.42
                                                        %
                                                        
                                                        
                                                        443
                                                        
                                                        
                                                        
                                                        13,403
                                                        
                                                        
                                                        
                                                        5.85
                                                        %
                                                        
                                                        
                                                        587Total
      borrowed funds
                                                        
                                                        
                                                        95,506
                                                        
                                                        
                                                        
                                                        1.31
                                                        %
                                                        
                                                        
                                                        938
                                                        
                                                        
                                                        
                                                        94,282
                                                        
                                                        
                                                        
                                                        3.09
                                                        %
                                                        
                                                        
                                                        2,180Total
      interest bearing liabilities
                                                        
                                                        
                                                        608,844
                                                        
                                                        
                                                        
                                                        1.61
                                                        %
                                                        
                                                        
                                                        7,351
                                                        
                                                        
                                                        
                                                        543,951
                                                        
                                                        
                                                        
                                                        2.38
                                                        %
                                                        
                                                        
                                                        9,693Non
      interest bearing demand
                                                        
                                                        
                                                        162,830
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        150,890Total
      funding
                                                        
                                                        
                                                        771,674
                                                        
                                                        
                                                        
                                                        1.27
                                                        %
                                                        
                                                        
                                                        7,351
                                                        
                                                        
                                                        
                                                        694,841
                                                        
                                                        
                                                        
                                                        1.86
                                                        %
                                                        
                                                        
                                                        9,693Other
      liabilities
                                                        
                                                        
                                                        8,650
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        7,894Total
      liabilities
                                                        
                                                        $
                                                        780,324
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        $
                                                        702,735Stockholders'
      Equity:Preferred
      stock
                                                        
                                                        $
                                                        13,741
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        $
                                                        -Common
      stock
                                                        
                                                        
                                                        48,673
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        46,269Additional
      paid in capital
                                                        
                                                        
                                                        2,504
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        806Retained
      earnings
                                                        
                                                        
                                                        23,166
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        24,739Valuation
      allowance investments
                                                        
                                                        
                                                        (1,750
                                                        )
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        (150
                                                        )Total
      stockholders' equity
                                                        
                                                        
                                                        86,334
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        71,664Total
      liabilities and stockholders' equity
                                                        
                                                        $
                                                        866,658
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        $
                                                        774,399Net
      interest income
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        $
                                                        28,674
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        $
                                                        28,234Net
      interest margin (3)
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        4.75
                                                        %
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        
                                                        5.26
                                                        %
 
 (1)
              Nonaccrual
      loans have been included in total
loans.
 (2)
              Loan
      fees of $711 and $1,008 for the nine months ending September 30, 2009 and
      2008, respectively have been included in interest income
      computation.
 (3)
              Net
      interest margin has been calculated by dividing the net interest income by
      total average earning assets.
 (4)
              Yield
      / Rate is annualized using actual number of days in
  period.
  | -
35 -
  
  Management’s
Discussion and Analysis
  The table
below sets forth changes in average interest earning assets and their respective
yields for the three and nine month periods ending September 30, 2009 compared
to the same period ended in 2008:
 
 Average Balance
                          
                          
                          
                          
                          
                          
                          
                          
                          Average Yieldfor the three months ending
                          
                          
                          
                          
                          
                          
                          
                          
                          for the three months endingSeptember 30,
                          
                          
                          Variance
                          
                          
                          September 30,(dollars in thousands)
                          
                          2009
                          
                          
                          2008
                          
                          
                          dollar
                          
                          
                          percentage
                          
                          
                          2009
                          
                          
                          2008
                          
                          
                          VarianceTime
      deposits with other banks
                          
                          $
                          119
                          
                          
                          $
                          128
                          
                          
                          $
                          (9
                          )
                          
                          
                          -7.03
                          %
                          
                          
                          3.33
                          %
                          
                          
                          3.11
                          %
                          
                          
                          0.22
                          %Federal
      funds sold
                          
                          
                          33,895
                          
                          
                          
                          3,342
                          
                          
                          
                          30,553
                          
                          
                          
                          914.21
                          %
                          
                          
                          0.25
                          %
                          
                          
                          2.14
                          %
                          
                          
                          -1.89
                          %Investment
      securities taxable
                          
                          
                          75,563
                          
                          
                          
                          43,221
                          
                          
                          
                          32,342
                          
                          
                          
                          74.83
                          %
                          
                          
                          4.66
                          %
                          
                          
                          5.52
                          %
                          
                          
                          -0.86
                          %Investment
      securities non-taxable
                          
                          
                          22,653
                          
                          
                          
                          17,125
                          
                          
                          
                          5,528
                          
                          
                          
                          32.28
                          %
                          
                          
                          4.33
                          %
                          
                          
                          4.32
                          %
                          
                          
                          0.01
                          %Loans
      (1) (2)
                          
                          
                          713,810
                          
                          
                          
                          667,441
                          
                          
                          
                          46,369
                          
                          
                          
                          6.95
                          %
                          
                          
                          5.95
                          %
                          
                          
                          6.99
                          %
                          
                          
                          -1.04
                          %Total
      interest earning assets
                          
                          $
                          846,040
                          
                          
                          $
                          731,257
                          
                          
                          $
                          114,783
                          
                          
                          
                          15.70
                          %
                          
                          
                          5.56
                          %
                          
                          
                          6.82
                          %
                          
                          
                          -1.26
                          %
 (1)
              Nonaccrual
      loans have been included in total
loans.
 (2)
              Loan
      fees of $229 and $285 for the three months ending September 30, 2009 and
      2008, respectively have been included in the interest income
      computation.
 
 Average Balance
                          
                          
                          
                          
                          
                          
                          
                          
                          Average Yieldfor the nine months ending
                          
                          
                          
                          
                          
                          
                          
                          
                          for the nine months endingSeptember 30,
                          
                          
                          Variance
                          
                          
                          September 30,(dollars in thousands)
                          
                          2009
                          
                          
                          2008
                          
                          
                          dollar
                          
                          
                          percentage
                          
                          
                          2009
                          
                          
                          2008
                          
                          
                          VarianceTime
      deposits with other banks
                          
                          $
                          119
                          
                          
                          $
                          246
                          
                          
                          $
                          (127
                          )
                          
                          
                          -51.63
                          %
                          
                          
                          3.37
                          %
                          
                          
                          3.80
                          %
                          
                          
                          -0.43
                          %Federal
      funds sold
                          
                          
                          22,596
                          
                          
                          
                          6,855
                          
                          
                          
                          15,741
                          
                          
                          
                          229.63
                          %
                          
                          
                          0.22
                          %
                          
                          
                          2.53
                          %
                          
                          
                          -2.31
                          %Investment
      securities taxable
                          
                          
                          59,614
                          
                          
                          
                          42,656
                          
                          
                          
                          16,958
                          
                          
                          
                          39.76
                          %
                          
                          
                          4.66
                          %
                          
                          
                          5.26
                          %
                          
                          
                          -0.60
                          %Investment
      securities non-taxable
                          
                          
                          19,763
                          
                          
                          
                          17,223
                          
                          
                          
                          2,540
                          
                          
                          
                          14.75
                          %
                          
                          
                          4.34
                          %
                          
                          
                          4.30
                          %
                          
                          
                          0.04
                          %Loans
      (1) (2)
                          
                          
                          705,187
                          
                          
                          
                          649,511
                          
                          
                          
                          55,676
                          
                          
                          
                          8.57
                          %
                          
                          
                          6.31
                          %
                          
                          
                          7.31
                          %
                          
                          
                          -1.00
                          %Total
      interest earning assets
                          
                          $
                          807,279
                          
                          
                          $
                          716,491
                          
                          
                          $
                          90,788
                          
                          
                          
                          12.67
                          %
                          
                          
                          5.97
                          %
                          
                          
                          7.07
                          %
                          
                          
                          -1.10
                          %
 (1)
              Nonaccrual
      loans have been included in total
loans.
 (2)
              Loan
      fees of $711 and $1,008 for the nine months ending September 30, 2009 and
      2008, respectively have been included in the interest income
      computation.
 
 At
September 30, 2009, average interest earning assets were approximately $114.8
million and $90.8 million higher than that reported over the same three and nine
month periods ended a year earlier.  Organic loan growth as well as
higher balances of Federal Funds sold and investment securities are the primary
factors behind the increase.
 
 For the
three and nine month periods ended September 30, 2009, the average yield on
loans was 5.95% and 6.31%, respectively.  This represents declines of
104 and 100 basis points from the 6.99% and 7.31% reported for the same periods
ended a year earlier.  As economic conditions worsened throughout
2008, the FOMC moved to cut the overnight Fed Funds rate by over 400 basis
points, which had a direct impact on yields in the loan
portfolio.  Further impacting the year over year decline in the yield
of the loan portfolio were interest reversals related to loans the Bank placed
on non-accrual during 2009.  As previously mentioned, the Bank
reversed approximately $0.8 million in interest income related to one loan,
which was recovered in October 2009.  The payment received from the
borrower of previously reversed interest allowed the Bank to move the loan back
to performing status.  However, as a result of the interest reversal
during the third quarter of 2009, the yield on earning assets was impacted by
approximately 40 and 14 basis points for the three and nine months ended
September 30, 2009, respectively.    The decline in the
yield of the loan portfolio is the primary factor contributing to the year over
year decline in the yield on earning assets.  Additionally, higher
average balances of Federal Funds sold, resulting from substantial deposit
growth during the first nine months of 2009, placed further pressure on earning
asset yields.  During the first nine months of 2009, the Bank made
selective purchases of mortgage related securities, in an effort to invest
excess liquidity in higher yielding, cash flow generating instruments, in the
absence of loan originations, to mitigate declines in the net interest
margin.   For the three and nine month periods ended September
30, 2009, the yield on earning assets declined approximately 126 and 110 basis
points when compared to the same periods ended a year ago.
  
 | - 36 -






Management’s
Discussion and Analysis





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





Average Balance
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            Average Ratefor the three months ending
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            for the three months endingSeptember 30,
                                            
                                            
                                            Variance
                                            
                                            
                                            September 30,(dollars
      in thousands)
                                            
                                            2009
                                            
                                            
                                            2008
                                            
                                            
                                            dollar
                                            
                                            
                                            percentage
                                            
                                            
                                            2009
                                            
                                            
                                            2008
                                            
                                            
                                            VarianceInterest
      bearing demand
                                            
                                            $
                                            67,825
                                            
                                            
                                            $
                                            74,042
                                            
                                            
                                            $
                                            (6,217
                                            )
                                            
                                            
                                            -8.40
                                            %
                                            
                                            
                                            0.92
                                            %
                                            
                                            
                                            0.47
                                            %
                                            
                                            
                                            0.45
                                            %Savings
                                            
                                            
                                            25,619
                                            
                                            
                                            
                                            23,272
                                            
                                            
                                            
                                            2,347
                                            
                                            
                                            
                                            10.09
                                            %
                                            
                                            
                                            0.28
                                            %
                                            
                                            
                                            0.43
                                            %
                                            
                                            
                                            -0.15
                                            %Money
      market
                                            
                                            
                                            209,634
                                            
                                            
                                            
                                            175,967
                                            
                                            
                                            
                                            33,667
                                            
                                            
                                            
                                            19.13
                                            %
                                            
                                            
                                            1.52
                                            %
                                            
                                            
                                            1.75
                                            %
                                            
                                            
                                            -0.23
                                            %Time
      deposits
                                            
                                            
                                            219,253
                                            
                                            
                                            
                                            144,490
                                            
                                            
                                            
                                            74,763
                                            
                                            
                                            
                                            51.74
                                            %
                                            
                                            
                                            2.32
                                            %
                                            
                                            
                                            3.06
                                            %
                                            
                                            
                                            -0.74
                                            %Brokered
      money market funds
                                            
                                            
                                            2,826
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            2,826
                                            
                                            
                                            
                                            100.00
                                            %
                                            
                                            
                                            0.70
                                            %
                                            
                                            
                                            0.00
                                            %
                                            
                                            
                                            0.70
                                            %Brokered
      time deposits
                                            
                                            
                                            23,426
                                            
                                            
                                            
                                            25,028
                                            
                                            
                                            
                                            (1,602
                                            )
                                            
                                            
                                            -6.40
                                            %
                                            
                                            
                                            1.46
                                            %
                                            
                                            
                                            3.35
                                            %
                                            
                                            
                                            -1.89
                                            %Federal
      funds purchased
                                            
                                            
                                            -
                                            
                                            
                                            
                                            4,583
                                            
                                            
                                            
                                            (4,583
                                            )
                                            
                                            
                                            -100.00
                                            %
                                            
                                            
                                            0.00
                                            %
                                            
                                            
                                            2.26
                                            %
                                            
                                            
                                            -2.26
                                            %Securities
      sold under repurchase agreements
                                            
                                            
                                            -
                                            
                                            
                                            
                                            2,327
                                            
                                            
                                            
                                            (2,327
                                            )
                                            
                                            
                                            -100.00
                                            %
                                            
                                            
                                            0.00
                                            %
                                            
                                            
                                            1.88
                                            %
                                            
                                            
                                            -1.88
                                            %Federal
      Home Loan Bank borrowing
                                            
                                            
                                            65,000
                                            
                                            
                                            
                                            89,408
                                            
                                            
                                            
                                            (24,408
                                            )
                                            
                                            
                                            -27.30
                                            %
                                            
                                            
                                            0.63
                                            %
                                            
                                            
                                            2.59
                                            %
                                            
                                            
                                            -1.96
                                            %Junior
      subordinated debentures
                                            
                                            
                                            13,403
                                            
                                            
                                            
                                            13,403
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            0.00
                                            %
                                            
                                            
                                            4.08
                                            %
                                            
                                            
                                            5.46
                                            %
                                            
                                            
                                            -1.38
                                            %Total
      interest bearing liabilities
                                            
                                            $
                                            626,986
                                            
                                            
                                            $
                                            552,520
                                            
                                            
                                            $
                                            74,466
                                            
                                            
                                            
                                            13.48
                                            %
                                            
                                            
                                            1.64
                                            %
                                            
                                            
                                            2.17
                                            %
                                            
                                            
                                            -0.53
                                            %





Average Balance
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  Average Rate`
                                  
                                  for the nine months ending
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  for the nine months endingSeptember 30,
                                  
                                  
                                  Variance
                                  
                                  
                                  September 30,(dollars in thousands)
                                  
                                  2009
                                  
                                  
                                  2008
                                  
                                  
                                  dollar
                                  
                                  
                                  percentage
                                  
                                  
                                  2009
                                  
                                  
                                  2008
                                  
                                  
                                  VarianceInterest
      bearing demand
                                  
                                  $
                                  64,524
                                  
                                  
                                  $
                                  74,886
                                  
                                  
                                  $
                                  (10,362
                                  )
                                  
                                  
                                  -13.84
                                  %
                                  
                                  
                                  0.72
                                  %
                                  
                                  
                                  0.61
                                  %
                                  
                                  
                                  0.11
                                  %Savings
                                  
                                  
                                  23,849
                                  
                                  
                                  
                                  26,834
                                  
                                  
                                  
                                  (2,985
                                  )
                                  
                                  
                                  -11.12
                                  %
                                  
                                  
                                  0.21
                                  %
                                  
                                  
                                  0.95
                                  %
                                  
                                  
                                  -0.74
                                  %Money
      market
                                  
                                  
                                  186,921
                                  
                                  
                                  
                                  189,181
                                  
                                  
                                  
                                  (2,260
                                  )
                                  
                                  
                                  -1.19
                                  %
                                  
                                  
                                  1.51
                                  %
                                  
                                  
                                  2.03
                                  %
                                  
                                  
                                  -0.52
                                  %Time
      deposits
                                  
                                  
                                  182,771
                                  
                                  
                                  
                                  142,919
                                  
                                  
                                  
                                  39,852
                                  
                                  
                                  
                                  27.88
                                  %
                                  
                                  
                                  2.49
                                  %
                                  
                                  
                                  3.43
                                  %
                                  
                                  
                                  -0.94
                                  %Brokered
      money market funds
                                  
                                  
                                  25,387
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  25,387
                                  
                                  
                                  
                                  100.00
                                  %
                                  
                                  
                                  0.72
                                  %
                                  
                                  
                                  0.00
                                  %
                                  
                                  
                                  0.72
                                  %Brokered
      time deposits
                                  
                                  
                                  29,886
                                  
                                  
                                  
                                  15,849
                                  
                                  
                                  
                                  14,037
                                  
                                  
                                  
                                  88.57
                                  %
                                  
                                  
                                  1.67
                                  %
                                  
                                  
                                  3.62
                                  %
                                  
                                  
                                  -1.95
                                  %Federal
      funds purchased
                                  
                                  
                                  251
                                  
                                  
                                  
                                  4,079
                                  
                                  
                                  
                                  (3,828
                                  )
                                  
                                  
                                  -93.85
                                  %
                                  
                                  
                                  1.07
                                  %
                                  
                                  
                                  2.69
                                  %
                                  
                                  
                                  -1.62
                                  %Securities
      sold under repurchase agreements
                                  
                                  
                                  870
                                  
                                  
                                  
                                  2,163
                                  
                                  
                                  
                                  (1,293
                                  )
                                  
                                  
                                  -59.78
                                  %
                                  
                                  
                                  0.15
                                  %
                                  
                                  
                                  2.35
                                  %
                                  
                                  
                                  -2.20
                                  %Federal
      Home Loan Bank borrowing
                                  
                                  
                                  80,982
                                  
                                  
                                  
                                  74,637
                                  
                                  
                                  
                                  6,345
                                  
                                  
                                  
                                  8.50
                                  %
                                  
                                  
                                  0.81
                                  %
                                  
                                  
                                  2.64
                                  %
                                  
                                  
                                  -1.83
                                  %Junior
      subordinated debentures
                                  
                                  
                                  13,403
                                  
                                  
                                  
                                  13,403
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  0.00
                                  %
                                  
                                  
                                  4.42
                                  %
                                  
                                  
                                  5.85
                                  %
                                  
                                  
                                  -1.43
                                  %Total
      interest bearing liabilities
                                  
                                  $
                                  608,844
                                  
                                  
                                  $
                                  543,951
                                  
                                  
                                  $
                                  64,893
                                  
                                  
                                  
                                  11.93
                                  %
                                  
                                  
                                  1.61
                                  %
                                  
                                  
                                  2.38
                                  %
                                  
                                  
                                  -0.77
                                  %





At
September 30, 2009, the balance of interest bearing liabilities was
approximately $74.5 million and $64.9 million higher than that reported over the
same three and nine month periods ended a year earlier.  Increases in
the average balance of interest bearing liabilities for the three and nine
months ended September 30, 2009 can be attributed in large part to higher money
market and time deposit balances.  The Bank attributes strong year
over year deposit growth to several factors including efforts in making its
brand top of mind in the Bank’s primary markets.  Growth can also be
attributed to the continued focus on providing excellent customer service as
well as marketing and promotional activities designed to attract additional core
deposits.  The Bank has also managed to attract deposits from some of
the larger institutions in its market.





Increases
in core deposits have allowed the Bank to pay down $44.0 million in FHLB
borrowings and approximately $31.6 million in brokered funds during the first
nine months of 2009.  The Bank’s focus on core deposit gathering has
also led to a year over year increase in the average balance of non-interest
bearing demand deposits, contributing to a decline in the Company’s cost of
funds of 41 and 59 basis points for the three and nine month periods ended
September 30, 2009, respectively, when compared to the same periods ended a year
earlier.





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







Heritage
Oaks Bancorp | - 37 -








Management’s
Discussion and Analysis








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





For the three months ended
                                
                                
                                For the nine months endedSeptember 30, 2009 over 2008
                                
                                
                                September 30, 2009 over 2008(dollars
      in thousands)
                                
                                Volume
                                
                                
                                Rate
                                
                                
                                Total
                                
                                
                                Volume
                                
                                
                                Rate
                                
                                
                                TotalInterest
      Income:Investments
      with other banks
                                
                                $
                                -
                                
                                
                                $
                                -
                                
                                
                                $
                                -
                                
                                
                                $
                                (4
                                )
                                
                                $
                                -
                                
                                
                                $
                                (4
                                )Federal
      funds sold
                                
                                
                                3
                                
                                
                                
                                -
                                
                                
                                
                                3
                                
                                
                                
                                (152
                                )
                                
                                
                                60
                                
                                
                                
                                (92
                                )Investment
      securities taxable
                                
                                
                                363
                                
                                
                                
                                (75
                                )
                                
                                
                                288
                                
                                
                                
                                556
                                
                                
                                
                                (160
                                )
                                
                                
                                396Investment
      securities non-taxable (2)
                                
                                
                                92
                                
                                
                                
                                -
                                
                                
                                
                                92
                                
                                
                                
                                123
                                
                                
                                
                                8
                                
                                
                                
                                131Taxable
      equivalent adjustment (2)
                                
                                
                                (31
                                )
                                
                                
                                -
                                
                                
                                
                                (31
                                )
                                
                                
                                (42
                                )
                                
                                
                                (3
                                )
                                
                                
                                (45
                                )Loans
      (1)
                                
                                
                                898
                                
                                
                                
                                (1,926
                                )
                                
                                
                                (1,028
                                )
                                
                                
                                3,810
                                
                                
                                
                                (6,098
                                )
                                
                                
                                (2,288
                                )Net
      increase (decrease)
                                
                                
                                1,325
                                
                                
                                
                                (2,001
                                )
                                
                                
                                (676
                                )
                                
                                
                                4,291
                                
                                
                                
                                (6,193
                                )
                                
                                
                                (1,902
                                )Interest
      Expense:Savings,
      NOW, money market
                                
                                
                                94
                                
                                
                                
                                (1
                                )
                                
                                
                                93
                                
                                
                                
                                (66
                                )
                                
                                
                                (843
                                )
                                
                                
                                (909
                                )Time
      deposits
                                
                                
                                323
                                
                                
                                
                                (150
                                )
                                
                                
                                173
                                
                                
                                
                                (19,856
                                )
                                
                                
                                19,584
                                
                                
                                
                                (272
                                )Brokered
      funds
                                
                                
                                (13
                                )
                                
                                
                                (107
                                )
                                
                                
                                (120
                                )
                                
                                
                                (143
                                )
                                
                                
                                224
                                
                                
                                
                                81Other
      borrowings
                                
                                
                                (145
                                )
                                
                                
                                (371
                                )
                                
                                
                                (516
                                )
                                
                                
                                74
                                
                                
                                
                                (1,172
                                )
                                
                                
                                (1,098
                                )Long
      term debt
                                
                                
                                -
                                
                                
                                
                                (46
                                )
                                
                                
                                (46
                                )
                                
                                
                                -
                                
                                
                                
                                (144
                                )
                                
                                
                                (144
                                )Net
      increase (decrease)
                                
                                
                                259
                                
                                
                                
                                (675
                                )
                                
                                
                                (416
                                )
                                
                                
                                (19,991
                                )
                                
                                
                                17,649
                                
                                
                                
                                (2,342
                                )Total
      net increase (decrease)
                                
                                $
                                1,066
                                
                                
                                $
                                (1,326
                                )
                                
                                $
                                (260
                                )
                                
                                $
                                24,282
                                
                                
                                $
                                (23,842
                                )
                                
                                $
                                440




(1)
              Loan
      fees of $229 and $285 for the three months ending September 30, 2009 and
      2008 and $711 and $1,008 for the nine months ending September 30, 2009 and
      2008, respectively.
 (2)
              Adjusted
      to a fully taxable equivalent basis using a tax rate of
    34%.




Non-Interest
Income





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





For the three months endedSeptember 30,
                        
                        
                        Variance(dollars
      in thousands)
                        
                        2009
                        
                        
                        2008
                        
                        
                        dollar
                        
                        
                        percentageService
      charges on deposit accounts
                        
                        $
                        750
                        
                        
                        $
                        878
                        
                        
                        $
                        (128
                        )
                        
                        
                        -14.58
                        %ATM/Debit
      and credit card transaction/interchange fees
                        
                        
                        253
                        
                        
                        
                        232
                        
                        
                        
                        21
                        
                        
                        
                        9.05
                        %Bancard
                        
                        
                        48
                        
                        
                        
                        69
                        
                        
                        
                        (21
                        )
                        
                        
                        -30.43
                        %Mortgage
      origination fees
                        
                        
                        245
                        
                        
                        
                        118
                        
                        
                        
                        127
                        
                        
                        
                        107.63
                        %Earnings
      on bank owned life insurance
                        
                        
                        124
                        
                        
                        
                        121
                        
                        
                        
                        3
                        
                        
                        
                        2.48
                        %Other
      commissions and fees
                        
                        
                        92
                        
                        
                        
                        95
                        
                        
                        
                        (3
                        )
                        
                        
                        -3.16
                        %Gain
      on sale of investment securities
                        
                        
                        211
                        
                        
                        
                        -
                        
                        
                        
                        211
                        
                        
                        
                        100.00
                        %Loss
      on sale of OREO
                        
                        
                        (200
                        )
                        
                        
                        -
                        
                        
                        
                        (200
                        )
                        
                        
                        100.00
                        %Gain
      on sale of SBA loans
                        
                        
                        70
                        
                        
                        
                        -
                        
                        
                        
                        70
                        
                        
                        
                        100.00
                        %Total
      non interest income
                        
                        $
                        1,593
                        
                        
                        $
                        1,513
                        
                        
                        $
                        80
                        
                        
                        
                        5.29
                        %





Heritage
Oaks Bancorp | - 38 -








Management’s
Discussion and Analysis







For the nine months endedSeptember 30,
                          
                          
                          Variance(dollars
      in thousands)
                          
                          2009
                          
                          
                          2008
                          
                          
                          dollar
                          
                          
                          percentageService
      charges on deposit accounts
                          
                          $
                          2,214
                          
                          
                          $
                          2,487
                          
                          
                          $
                          (273
                          )
                          
                          
                          -10.98
                          %ATM/Debit
      and credit card transaction/interchange fees
                          
                          
                          723
                          
                          
                          
                          671
                          
                          
                          
                          52
                          
                          
                          
                          7.75
                          %Bancard
                          
                          
                          140
                          
                          
                          
                          183
                          
                          
                          
                          (43
                          )
                          
                          
                          -23.50
                          %Mortgage
      origination fees
                          
                          
                          910
                          
                          
                          
                          367
                          
                          
                          
                          543
                          
                          
                          
                          147.96
                          %Earnings
      on bank owned life insurance
                          
                          
                          369
                          
                          
                          
                          352
                          
                          
                          
                          17
                          
                          
                          
                          4.83
                          %Other
      commissions and fees
                          
                          
                          325
                          
                          
                          
                          611
                          
                          
                          
                          (286
                          )
                          
                          
                          -46.81
                          %Gain
      on sale of investment securities
                          
                          
                          333
                          
                          
                          
                          37
                          
                          
                          
                          296
                          
                          
                          
                          800.00
                          %Loss
      on sale of OREO
                          
                          
                          (331
                          )
                          
                          
                          -
                          
                          
                          
                          (331
                          )
                          
                          
                          100.00
                          %Gain
      on sale of SBA loans
                          
                          
                          70
                          
                          
                          
                          -
                          
                          
                          
                          70
                          
                          
                          
                          100.00
                          %Total
      non interest income
                          
                          $
                          4,753
                          
                          
                          $
                          4,708
                          
                          
                          $
                          45
                          
                          
                          
                          0.96
                          %





Non-interest
income for the three and nine months ended September 30, 2009 increased
approximately $80 thousand or 5.3% and $45 thousand or 1.0%, respectively when
compared to the same periods ended in 2008.  Contributing
substantially to the year over year increases were significantly higher mortgage
origination fee income as well as gains the Bank recognized in connection with
the sale of investment securities and SBA loans.  Offsetting these
increases were declines in service charge fee income as well as losses the Bank
incurred on the sale of OREO properties.  Additionally, the absence of
income the Bank recognized in the approximate amount of $0.3 million during the
second quarter of 2008 in connection with the Visa, Inc. IPO contributed to the
year to date decline within the category of “other commissions and
fees.”





During
the third quarter of 2009, the Bank sold $11.3 million in investment securities
and recognized an aggregate pre-tax gain of approximately $0.2
million.  During the first nine months of 2009, the Bank sold
approximately $16.0 million in investment securities and recognized pre-tax
gains of approximately $0.3 million.





Non-interest
income for the three and nine month periods ended September 30, 2009 was
negatively impacted by year over year declines in service charge fee income,
primarily the result of a decline in NSF fee income.  Service charges
on deposit accounts declined approximately $0.1 million and $0.3 million during
the three and nine months ended September 30, 2009 when compared to the same
periods ended a year earlier.





Contributing
significantly to the year over year increases in non-interest income were
significant increases in mortgage origination fees.  Income within
this category increased approximately $0.1 million or 107.6% and $0.5 million or
148.0% during the three and nine month periods ended September 30, 2009, when
compared to the same periods ended a year earlier.  The Bank witnessed
a significant increase in the number of home loan re-financings during the first
nine months of 2009 when compared to the same period ended a year earlier as a
result of a significantly lower rate environment.





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





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





For the three months ended September 30,(dollars in thousands)
                  
                  2009
                  
                  
                  2008
                  
                  
                  VarianceDollar
      volume
                  
                  $
                  38,993
                  
                  
                  $
                  14,710
                  
                  
                  
                  165.1
                  %Number
      of loans
                  
                  
                  99
                  
                  
                  
                  35
                  
                  
                  
                  182.9
                  %





For the nine months ended September 30,(dollars in thousands)
                  
                  2009
                  
                  
                  2008
                  
                  
                  VarianceDollar
      volume
                  
                  $
                  127,680
                  
                  
                  $
                  44,087
                  
                  
                  
                  189.6
                  %Number
      of loans
                  
                  
                  377
                  
                  
                  
                  118
                  
                  
                  
                  219.5
                  %





Heritage
Oaks Bancorp | - 39 -





Management’s
Discussion and Analysis







Non-Interest
Expenses





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





For the three months endedSeptember 30,
                          
                          
                          Variance(dollars in thousands)
                          
                          2009
                          
                          
                          2008
                          
                          
                          dollar
                          
                          
                          percentageSalaries
      and employee benefits
                          
                          $
                          3,969
                          
                          
                          $
                          3,651
                          
                          
                          $
                          318
                          
                          
                          
                          8.71
                          %Occupancy
                          
                          
                          843
                          
                          
                          
                          741
                          
                          
                          
                          102
                          
                          
                          
                          13.77
                          %Equipment
                          
                          
                          365
                          
                          
                          
                          335
                          
                          
                          
                          30
                          
                          
                          
                          8.96
                          %Promotional
                          
                          
                          191
                          
                          
                          
                          199
                          
                          
                          
                          (8
                          )
                          
                          
                          -4.02
                          %Data
      processing
                          
                          
                          687
                          
                          
                          
                          672
                          
                          
                          
                          15
                          
                          
                          
                          2.23
                          %Stationery
      and supplies
                          
                          
                          111
                          
                          
                          
                          99
                          
                          
                          
                          12
                          
                          
                          
                          12.12
                          %Regulatory
      fees
                          
                          
                          851
                          
                          
                          
                          116
                          
                          
                          
                          735
                          
                          
                          
                          633.62
                          %Audit
      and tax costs
                          
                          
                          182
                          
                          
                          
                          114
                          
                          
                          
                          68
                          
                          
                          
                          59.65
                          %Amortization
      of core deposit intangible
                          
                          
                          262
                          
                          
                          
                          215
                          
                          
                          
                          47
                          
                          
                          
                          21.86
                          %Director
      fees
                          
                          
                          80
                          
                          
                          
                          80
                          
                          
                          
                          -
                          
                          
                          
                          0.00
                          %Communications
                          
                          
                          76
                          
                          
                          
                          87
                          
                          
                          
                          (11
                          )
                          
                          
                          -12.64
                          %Other
                          
                          
                          2,634
                          
                          
                          
                          799
                          
                          
                          
                          1,835
                          
                          
                          
                          229.66
                          %Total non interest expense
                          
                          $
                          10,251
                          
                          
                          $
                          7,108
                          
                          
                          $
                          3,143
                          
                          
                          
                          44.22
                          %





For
      the nine months endedSeptember 30,
                          
                          
                          Variance(dollars in thousands)
                          
                          2009
                          
                          
                          2008
                          
                          
                          dollar
                          
                          
                          percentageSalaries
      and employee benefits
                          
                          $
                          11,517
                          
                          
                          $
                          11,897
                          
                          
                          $
                          (380
                          )
                          
                          
                          -3.19
                          %Occupancy
                          
                          
                          2,521
                          
                          
                          
                          2,291
                          
                          
                          
                          230
                          
                          
                          
                          10.04
                          %Equipment
                          
                          
                          1,066
                          
                          
                          
                          1,053
                          
                          
                          
                          13
                          
                          
                          
                          1.23
                          %Promotional
                          
                          
                          517
                          
                          
                          
                          681
                          
                          
                          
                          (164
                          )
                          
                          
                          -24.08
                          %Data
      processing
                          
                          
                          2,049
                          
                          
                          
                          1,998
                          
                          
                          
                          51
                          
                          
                          
                          2.55
                          %Stationery
      and supplies
                          
                          
                          314
                          
                          
                          
                          323
                          
                          
                          
                          (9
                          )
                          
                          
                          -2.79
                          %Regulatory
      fees
                          
                          
                          1,531
                          
                          
                          
                          340
                          
                          
                          
                          1,191
                          
                          
                          
                          350.29
                          %Audit
      and tax costs
                          
                          
                          477
                          
                          
                          
                          342
                          
                          
                          
                          135
                          
                          
                          
                          39.47
                          %Amortization
      of core deposit intangible
                          
                          
                          787
                          
                          
                          
                          646
                          
                          
                          
                          141
                          
                          
                          
                          21.83
                          %Director
      fees
                          
                          
                          243
                          
                          
                          
                          238
                          
                          
                          
                          5
                          
                          
                          
                          2.10
                          %Communications
                          
                          
                          199
                          
                          
                          
                          239
                          
                          
                          
                          (40
                          )
                          
                          
                          -16.74
                          %Other
                          
                          
                          4,469
                          
                          
                          
                          2,178
                          
                          
                          
                          2,291
                          
                          
                          
                          105.19
                          %Total non interest expense
                          
                          $
                          25,690
                          
                          
                          $
                          22,226
                          
                          
                          $
                          3,464
                          
                          
                          
                          15.59
                          %




Salary
and Employee Benefits





Salaries
and employee related expenses increased approximately $318 thousand during the
three months ended September 30, 2009 when compared to that reported in the same
period ended a year earlier.  Staff additions during the third quarter
in response to the growth of the Bank contributed significantly to the rise
within this category.





For the
first nine months of 2009, the Bank saw expenses within this category decline
approximately $380 thousand when compared to that reported during the same
period ended a year ago.  Efficiencies the Bank gained with respect to
staffing during the later part of 2008 and early in 2009 contributed to the
majority of the year over year decline within this category.





Occupancy
Expenses





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








Promotion
Expenses





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








Heritage
Oaks Bancorp | - 40 -





Management’s
Discussion and Analysis





Regulatory
Fees





For the
three and nine months ended September 30, 2009, regulatory fees were
approximately $735 thousand and $1.2 million higher than that reported for the
same periods ended a year earlier.  During the second quarter of 2009
the Bank took a one-time charge in the approximate amount of $0.4 million
related to a special assessment imposed by the FDIC on all insured institutions
with the intent to replenish the Deposit Insurance Fund.  The year
over year increase within this category for both the three and nine months ended
September 30, 2009 can also be attributed to a one-time charge in the
approximate amount of $0.5 million to correct for the cumulative effect of an
accounting error related to the accrual of FDIC assessments that covered ten
reporting periods.  Management determined that the shortage in the
accrual was not material to the Company’s financial statements in any one
reporting period and as such, processed the correcting entry in the third
quarter of 2009.





In
addition to the items mentioned above regular quarterly assessment fees imposed
by the FDIC have also increased from year ago levels and may increase further
throughout the remainder of 2009.





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 will be amortized
over a six year period pursuant to a schedule provided in the initial valuation
process.  For the three and nine months ended September 30, 2009 CDI
amortization was approximately $47 thousand and $142 thousand higher than that
reported for the same periods ended in 2008 of which substantially all can be
attributed to the Business First acquisition.





Other
Expenses





Expenses
within this category increased approximately $1.8 million and $2.3 million
during the three and nine months ended September 30, 2009 when compared to the
same periods ended a year ago.  The majority of the increase within
this category can be attributed to the write-down of a single OREO property
during the third quarter of 2009 in the approximate amount of $1.3
million.  This property represents land for commercial development and
is located in the Bank’s primary market area.  Total OREO write-downs
for the three and nine months ended September 30, 2009 were approximately $1.4
million and $1.5 million, respectively.





The Bank
also incurred other expenses related to OREO and other foreclosed
collateral.  These expenses totaled approximately $0.3 million and
$0.6 million for the three and nine months ended September 30, 2009,
respectively.





Year over
year increases within this category can also be attributed to increased loan
department costs related to  expenses incurred for appraisals and
collection efforts.  Loan department costs increased approximately $74
thousand and $179 thousand during the three and nine month periods ended
September 30, 2009 when compared to the same periods ended a year
ago.





Exclusive
of one-time expenses mentioned in the preceding paragraphs as well as various
expenses the Bank incurred related to OREO and foreclosed collateral,
non-interest expense increased approximately $0.8 million or 11.9% and $0.4
million and 2.0% for the three and nine month periods ended September 30,
2009.





Provision
for Income Taxes





For the
three and nine month periods ended September 30, 2009 the Company recorded an
income tax benefit of approximately $3.9 million and $3.2 million,
respectively.  This compares to the $0.2 million and $1.6 million in
income tax expense the Company recorded for the same periods ended in
2008.  The year over year declines within this category can be
attributed in large part to substantial increases in provisions for loan losses
throughout 2009 as well as other significant one-time
expenses.  Income tax benefits for the three and nine month periods
ended September 30, 2009 were 42.7% and 46.8% of the Company’s pre-tax loss for
those periods.  The effective tax rate for the same periods ended a
year earlier was 26.8% and 35.6%.  The primary reason behind the
increase in the Company’s effective tax rate can be attributed in large part to
the approximate $0.5 million and $1.2 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.





Heritage
Oaks Bancorp | - 41 -





Management’s
Discussion and Analysis





Provision
for Loan Losses





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





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





The Bank
accounts for problem loans in accordance with 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 credit
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.  The general portfolio allocation of the allowance consists of
assigned reserve percentages based on credit ratings of loans in the
portfolio.  The subjective portion is determined based on loan history
and the Bank’s evaluation of various factors including current economic
conditions and trends in the portfolio including delinquencies and impairment,
as well as changes in the composition of the portfolio.





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





The
Bank’s provision for loan losses was $9.8 million and $14.6 million for the
three and nine month periods ended September 30, 2009 compared to provisions of
$3.2 million and $6.2 million for the same periods ended a year
earlier.  Provisions made to the allowance for loan losses during the
third quarter and first nine months of 2009, were approximately $6.6 million and
$8.4 million higher than that reported for the same periods ended a year
earlier.  As economic conditions throughout the later part of 2008 and
into 2009 worsened on national, state and local levels, the Bank moved to
increase the allowance as required by monthly analyses it conducts in
determining its adequacy to cover potential losses in the loan
portfolio.  In addition, during the third quarter the Bank’s
independent loan review firm completed its semi-annual loan portfolio
examination to augment Management’s internal loan review.  As a result
of feedback from this review, in connection with our own effort to identify and
reserve for perceived credit risks in the portfolio and due to the continuation
of worsening economic conditions, we moved approximately $34.2 million in loan
balances to non-accruing status.  This increase in non-accrual loans
contributed significantly to the increased provision in the third quarter.The
Bank employs the use of a “watch list” and loan grading system to assist in
monitoring the quality of certain credits in the loan portfolio.  As
loans on the watch list and any other loan within the portfolio experience
deterioration, the Bank typically moves to downgrade such loans, resulting in an
increase in the required allowance to cover any potential
losses.  During the third quarter of 2009, 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 that has continued into 2009 has had a considerable
impact on the ability of certain borrowers to satisfy their obligations to the
Bank, resulting in continued watch list expansion, loan downgrades and
corresponding increases in loan loss provisions.  At September 30,
2009 the balance of loans the Bank has graded “substandard” totaled
approximately $81.6 million, of which approximately $39.4 million were
non-accruing. However, as disclosed in Note 10. Subsequent Events, of the
consolidated financial statements, total non-accruing loans were reduced by
$10.7 million during the month of October 2009.





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 have continued thus far into 2009 and contributed
substantially to increases in the required allowance to cover potential losses
in the loan portfolio, resulting in year over year increases in loan loss
provisions.





Heritage
Oaks Bancorp | - 42 -





Management’s
Discussion and Analysis





Charge-offs
in the commercial and industrial, agriculture, construction and land segments of
the loan portfolio during the first nine months of 2009 when compared to the
same period ended a year earlier increased significantly, mainly attributable to
several large write-downs.  These losses in conjunction with an
increase in the number and total dollar volume of past due loans within these
segments has further contributed to the additional provisions the Bank made to
the allowance for loan losses when compared to the year ago
periods.  Additionally, non-accruing balances when compared to that
reported a year ago, and relative to historical periods remain elevated, also
contributing to increased loan loss provisions.  Continued increases
in the level of charge-offs, the number and dollar volume of past due,
non-accruing and non-performing loans and any further significant downturn in
economic conditions may result in further significant provisions to the
allowance for loan losses.





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





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





Heritage
Oaks Bancorp | - 43 -







Management’s
Discussion and Analysis





Financial
Condition





At
September 30, 2009, total assets were $926.8 million.  This when
compared to the $805.6 million reported at December 31, 2008, represents an
increase of approximately $121.2 million or 15.1%.  Increases in
investment securities, Federal Funds sold, and net loan balances were primary
factors behind the year to date increase in total assets.  An increase
of $39.1 million in the balance of Federal Funds sold is attributable to the
dramatic increases the Bank saw in deposit balances during the first nine months
of 2009.  Net increases in the investment portfolio of approximately
$52.1 million are the result of purchases the Bank made during 2009 to take
advantage of increased credit spreads on investment securities and to invest
excess liquidity in higher yielding cash flow producing instruments in the
absence of loan funding.  During the first nine months of 2009, net
loan balances grew approximately $24.3 million, contributing to overall growth
in total assets.





At
September 30, 2009, total deposits were approximately $753.5 million or
approximately $150.0 million higher than the $603.5 million reported at December
31, 2008.  Increases in non-interest bearing demand, money market and
retail time deposits contributed to the year to date increase in
deposits.  Deposit growth during the first nine months of 2009 allowed
the Bank to pay down brokered funds as well as borrowings with the
FHLB.  Net of the pay down in brokered funds, total deposits grew
approximately $181.6 million from that reported at December 31,
2008.  During the first nine months of 2009, FHLB borrowings declined
$44.0 million.  See also “Deposits and Borrowed Funds” of this
Discussion and Analysis for additional information related to the changes in
deposit balances and wholesale borrowings.





Loans





At
September 30, 2009 total gross loan balances were $709.9
million.  This represents an increase of approximately $29.8 million
or 4.4% from the $680.1 million reported at December 31, 2008.  Higher
commercial real estate and commercial loan balances contributed to the majority
of the year to date increase in the portfolio.  These loans were made
to borrowers within the Bank’s primary market area and to borrowers within the
industries of professional, commercial and hospitality.





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





September 30,
                              
                              
                              December 31,
                              
                              
                              Variance(dollars in thousands)
                              
                              2009
                              
                              
                              2008
                              
                              
                              dollar
                              
                              
                              percentageReal
      Estate SecuredMulti-family
      residential
                              
                              $
                              17,323
                              
                              
                              $
                              16,206
                              
                              
                              $
                              1,117
                              
                              
                              
                              6.89
                              %Residential
      1 to 4 family
                              
                              
                              24,580
                              
                              
                              
                              23,910
                              
                              
                              
                              670
                              
                              
                              
                              2.80
                              %Home
      equity line of credit
                              
                              
                              29,189
                              
                              
                              
                              26,409
                              
                              
                              
                              2,780
                              
                              
                              
                              10.52
                              %Commercial
                              
                              
                              317,811
                              
                              
                              
                              285,631
                              
                              
                              
                              32,180
                              
                              
                              
                              11.27
                              %Farmland
                              
                              
                              9,842
                              
                              
                              
                              10,723
                              
                              
                              
                              (881
                              )
                              
                              
                              -8.22
                              %CommercialCommercial
      and industrial
                              
                              
                              166,618
                              
                              
                              
                              157,674
                              
                              
                              
                              8,944
                              
                              
                              
                              5.67
                              %Agriculture
                              
                              
                              14,819
                              
                              
                              
                              13,744
                              
                              
                              
                              1,075
                              
                              
                              
                              7.83
                              %Other
                              
                              
                              368
                              
                              
                              
                              620
                              
                              
                              
                              (252
                              )
                              
                              
                              -40.57
                              %ConstructionSingle
      family residential
                              
                              
                              14,669
                              
                              
                              
                              11,414
                              
                              
                              
                              3,255
                              
                              
                              
                              28.52
                              %Single
      family residential - Spec.
                              
                              
                              5,757
                              
                              
                              
                              15,395
                              
                              
                              
                              (9,638
                              )
                              
                              
                              -62.60
                              %Tract
                              
                              
                              2,215
                              
                              
                              
                              2,431
                              
                              
                              
                              (216
                              )
                              
                              
                              -8.88
                              %Multi-family
                              
                              
                              5,575
                              
                              
                              
                              5,808
                              
                              
                              
                              (233
                              )
                              
                              
                              -4.02
                              %Hospitality
                              
                              
                              14,252
                              
                              
                              
                              18,630
                              
                              
                              
                              (4,378
                              )
                              
                              
                              -23.50
                              %Commercial
                              
                              
                              22,997
                              
                              
                              
                              21,484
                              
                              
                              
                              1,513
                              
                              
                              
                              7.04
                              %Land
                              
                              
                              54,619
                              
                              
                              
                              61,681
                              
                              
                              
                              (7,062
                              )
                              
                              
                              -11.45
                              %Installment
      loans to individuals
                              
                              
                              8,863
                              
                              
                              
                              7,851
                              
                              
                              
                              1,012
                              
                              
                              
                              12.89
                              %All
      other loans (including overdrafts)
                              
                              
                              370
                              
                              
                              
                              536
                              
                              
                              
                              (166
                              )
                              
                              
                              -31.03
                              %Total loans, gross
                              
                              
                              709,867
                              
                              
                              
                              680,147
                              
                              
                              
                              29,720
                              
                              
                              
                              4.37
                              %Deferred
      loan fees
                              
                              
                              1,635
                              
                              
                              
                              1,701
                              
                              
                              
                              (66
                              )
                              
                              
                              -3.87
                              %Reserve for possible loan
      losses
                              
                              
                              15,873
                              
                              
                              
                              10,412
                              
                              
                              
                              5,461
                              
                              
                              
                              52.45
                              %Total loans, net
                              
                              $
                              692,359
                              
                              
                              $
                              668,034
                              
                              
                              $
                              24,325
                              
                              
                              
                              3.64
                              %Loans
      held for sale
                              
                              $
                              7,778
                              
                              
                              $
                              7,939
                              
                              
                              $
                              (161
                              )
                              
                              
                              -2.03
                              %





Heritage
Oaks Bancorp | - 44 -





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 September 30, 2009:





September 30, 2009
                          
                          
                          
                          
                          
                          Percent of
                          
                          
                          
                          
                          
                          SingleUndisbursed
                          
                          
                          Total Bank
                          
                          
                          Percent
                          
                          
                          Bank's Risk
                          
                          
                          Number
                          
                          
                          Largest(dollars
      in thousands)
                          
                          Balance
                          
                          
                          Commitment
                          
                          
                          Exposure
                          
                          
                          Composition
                          
                          
                          Based
      Capital
                          
                          
                          of
      Loans
                          
                          
                          LoanRetail
                          
                          $
                          44,831
                          
                          
                          $
                          3,041
                          
                          
                          $
                          47,872
                          
                          
                          
                          11.2
                          %
                          
                          
                          55.0
                          %
                          
                          
                          62
                          
                          
                          $
                          5,000Professional
                          
                          
                          81,786
                          
                          
                          
                          328
                          
                          
                          
                          82,114
                          
                          
                          
                          19.3
                          %
                          
                          
                          94.3
                          %
                          
                          
                          104
                          
                          
                          
                          9,000Hospitality
                          
                          
                          71,562
                          
                          
                          
                          115
                          
                          
                          
                          71,677
                          
                          
                          
                          16.8
                          %
                          
                          
                          82.3
                          %
                          
                          
                          40
                          
                          
                          
                          10,981Multi-family
                          
                          
                          17,323
                          
                          
                          
                          -
                          
                          
                          
                          17,323
                          
                          
                          
                          4.1
                          %
                          
                          
                          19.9
                          %
                          
                          
                          20
                          
                          
                          
                          4,066Home
      equity lines of credit
                          
                          
                          29,189
                          
                          
                          
                          20,146
                          
                          
                          
                          49,335
                          
                          
                          
                          11.6
                          %
                          
                          
                          56.7
                          %
                          
                          
                          317
                          
                          
                          
                          1,680Residential
      1 to 4 family
                          
                          
                          24,580
                          
                          
                          
                          569
                          
                          
                          
                          25,149
                          
                          
                          
                          5.9
                          %
                          
                          
                          28.9
                          %
                          
                          
                          70
                          
                          
                          
                          3,000Farmland
                          
                          
                          9,842
                          
                          
                          
                          1,316
                          
                          
                          
                          11,158
                          
                          
                          
                          2.6
                          %
                          
                          
                          12.8
                          %
                          
                          
                          23
                          
                          
                          
                          1,937Healthcare
      / medical
                          
                          
                          15,963
                          
                          
                          
                          -
                          
                          
                          
                          15,963
                          
                          
                          
                          3.7
                          %
                          
                          
                          18.3
                          %
                          
                          
                          31
                          
                          
                          
                          2,155Restaurants
      / food establishments
                          
                          
                          7,381
                          
                          
                          
                          -
                          
                          
                          
                          7,381
                          
                          
                          
                          1.7
                          %
                          
                          
                          8.5
                          %
                          
                          
                          14
                          
                          
                          
                          2,541Commercial
                          
                          
                          79,230
                          
                          
                          
                          1,742
                          
                          
                          
                          80,972
                          
                          
                          
                          19.0
                          %
                          
                          
                          93.0
                          %
                          
                          
                          114
                          
                          
                          
                          4,714Other
                          
                          
                          17,058
                          
                          
                          
                          -
                          
                          
                          
                          17,058
                          
                          
                          
                          4.1
                          %
                          
                          
                          19.6
                          %
                          
                          
                          29
                          
                          
                          
                          2,100Total
      real estate secured
                          
                          $
                          398,745
                          
                          
                          $
                          27,257
                          
                          
                          $
                          426,002
                          
                          
                          
                          100.0
                          %
                          
                          
                          489.3
                          %
                          
                          
                          824
                          
                          
                          $
                          47,174





As of
September 30, 2009, real estate secured balances represented approximately
$398.7 million of total gross loans.  This when compared to the $362.9
million reported at December 31, 2008, represents an increase of approximately
$35.8 million or 9.9%.  The primary factor behind the year to date
increase can be attributed to higher commercial real estate
balances.  Year to date increases within this category can be
attributed to the completion of several large construction projects and their
subsequent reclassification from construction to commercial real
estate.  The aggregate balance of these large loans was approximately
$14.9 million at September 30, 2009.  During the third quarter of 2009
the Bank funded one $9.0 million credit for the purpose of purchasing
professional office space, occupied by three national tenants.  This
credit was originated with a loan to value of 50% and a debt coverage ratio of
2.4 times. During the first nine months of the year the Bank also made
several new loans in excess of $1.0 million.  The aggregate balance of
these loans was approximately $22.6 million as of September 30,
2009.  These new loans were made to borrowers in the industries of
professional, commercial and hospitality.  The Bank also had several
large payoffs and pay downs in excess of $0.5 million during the first nine
months of the year, totaling approximately $5.6 million.





Loans
classified as multi-family residential also contributed to the year to date
increase within the real estate secured portfolio.  Contributing
substantially to the year to date increase was the funding of one loan in the
aggregate amount of $2.3 million.  This loan was made for a government
subsidized low income housing project  within the Bank’s primary
market.  Notable pay downs within this category include the pay down
of one loan in the aggregate amount of $1.5 million.





HELOC
disbursements also contributed to the year to date increase within the real
estate secured portfolio, rising approximately $2.8 million from the $26.4
million reported at December 31, 2008.





At
September 30, 2009, real estate secured commitments represented approximately
489.3% of the Bank’s total risk based capital.  This when compared to
the 510.7% reported at December 31, 2008, represents a decline of 21.4
percentage points.  The additional capital obtained under the U.S.
Treasury’s CPP is the primary factor behind the year to date
decline.  While the real estate secured portfolio in aggregate
represents a concentration, no single category within this segment of the
portfolio is considered a concentration as of September 30, 2009.





At
September 30, 2009, approximately $162.4 million or 40.7% of the real estate
secured segment of the loan portfolio was considered owner
occupied.





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





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





Heritage
Oaks Bancorp | - 45 -





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 September 30, 2009:





September 30, 2009
                        
                        
                        
                        
                        
                        Percent of
                        
                        
                        
                        
                        
                        SingleUndisbursed
                        
                        
                        Total Bank
                        
                        
                        Percent
                        
                        
                        Bank's Risk
                        
                        
                        Number
                        
                        
                        Largest(dollars in thousands)
                        
                        Balance
                        
                        
                        Commitment
                        
                        
                        Exposure
                        
                        
                        Composition
                        
                        
                        BasedCapital
                        
                        
                        of Loans
                        
                        
                        LoanAgriculture
                        
                        $
                        3,060
                        
                        
                        $
                        3,550
                        
                        
                        $
                        6,610
                        
                        
                        
                        2.7
                        %
                        
                        
                        7.6
                        %
                        
                        
                        29
                        
                        
                        $
                        2,000Oil
      / Gas and Utilities
                        
                        
                        2,110
                        
                        
                        
                        1,091
                        
                        
                        
                        3,201
                        
                        
                        
                        1.3
                        %
                        
                        
                        3.7
                        %
                        
                        
                        10
                        
                        
                        
                        1,200Construction
                        
                        
                        19,425
                        
                        
                        
                        15,278
                        
                        
                        
                        34,703
                        
                        
                        
                        13.9
                        %
                        
                        
                        39.9
                        %
                        
                        
                        171
                        
                        
                        
                        2,750Manufacturing
                        
                        
                        10,520
                        
                        
                        
                        8,960
                        
                        
                        
                        19,480
                        
                        
                        
                        7.8
                        %
                        
                        
                        22.4
                        %
                        
                        
                        101
                        
                        
                        
                        1,675Wholesale
      and Retail
                        
                        
                        15,441
                        
                        
                        
                        6,447
                        
                        
                        
                        21,888
                        
                        
                        
                        8.8
                        %
                        
                        
                        25.1
                        %
                        
                        
                        126
                        
                        
                        
                        1,250Transportation
      and Warehousing
                        
                        
                        2,710
                        
                        
                        
                        716
                        
                        
                        
                        3,426
                        
                        
                        
                        1.4
                        %
                        
                        
                        3.9
                        %
                        
                        
                        34
                        
                        
                        
                        596Media
      & Information Services
                        
                        
                        10,153
                        
                        
                        
                        1,724
                        
                        
                        
                        11,877
                        
                        
                        
                        4.8
                        %
                        
                        
                        13.6
                        %
                        
                        
                        28
                        
                        
                        
                        8,000Financial
      Services
                        
                        
                        18,626
                        
                        
                        
                        2,825
                        
                        
                        
                        21,451
                        
                        
                        
                        8.6
                        %
                        
                        
                        24.6
                        %
                        
                        
                        50
                        
                        
                        
                        6,000Real-Estate
      / Rental and Leasing
                        
                        
                        16,237
                        
                        
                        
                        9,369
                        
                        
                        
                        25,606
                        
                        
                        
                        10.3
                        %
                        
                        
                        29.4
                        %
                        
                        
                        89
                        
                        
                        
                        3,500Professional
      Services
                        
                        
                        18,990
                        
                        
                        
                        8,510
                        
                        
                        
                        27,500
                        
                        
                        
                        11.0
                        %
                        
                        
                        31.6
                        %
                        
                        
                        150
                        
                        
                        
                        1,994Healthcare
      / Medical & Social Services
                        
                        
                        19,232
                        
                        
                        
                        20,434
                        
                        
                        
                        39,666
                        
                        
                        
                        15.9
                        %
                        
                        
                        45.6
                        %
                        
                        
                        119
                        
                        
                        
                        11,355Restaurants
      and Hospitality
                        
                        
                        22,943
                        
                        
                        
                        2,966
                        
                        
                        
                        25,909
                        
                        
                        
                        10.4
                        %
                        
                        
                        29.8
                        %
                        
                        
                        116
                        
                        
                        
                        6,000All
      Other
                        
                        
                        7,171
                        
                        
                        
                        502
                        
                        
                        
                        7,673
                        
                        
                        
                        3.1
                        %
                        
                        
                        8.8
                        %
                        
                        
                        56
                        
                        
                        
                        2,062Commercial
      and industrial
                        
                        $
                        166,618
                        
                        
                        $
                        82,372
                        
                        
                        $
                        248,990
                        
                        
                        
                        100.0
                        %
                        
                        
                        286.0
                        %
                        
                        
                        1,079
                        
                        
                        $
                        48,382





At
September 30, 2009, commercial and industrial loans represented approximately
$166.6 million of total gross loan balances.  This when compared to
the $157.7 million reported at December 31, 2008, represents an increase of
approximately $8.9 million or 5.6%.  Increases in the commercial and
industrial and agriculture categories were the primary factors behind the year
to date increase.





During
the first nine months of the year the Bank made several new loans as well as
notable disbursements in amounts in excess of $1.0 million, totaling
approximately $15.6 million.  These new loans and disbursements were
made to borrowers in the following industries: healthcare / medical, wholesale
and retail, real estate / rental and leasing, oil / gas and utilities, and
restaurants and hospitality.





Although
the commercial and industrial category as a whole does represent a concentration
at 286.0% of the Bank’s total risk based capital, there was no one particular
industry to which the Bank has extended credit within the commercial and
industrial category that represented a concentration as of September 30,
2009. At September 30, 2009, commercial and industrial commitments as a
percent of the Bank’s total risk based capital were approximately 286.0% or 38.0
percentage points lower than the 324.0% reported at December 31,
2008.  The additional capital obtained under the U.S. Treasury’s CPP
is the primary factor behind the year to date decline.





At
September 30, 2009 agriculture balances totaled approximately $14.8 million,
which represents an approximate $1.1 million increase when compared to the $13.7
million reported at December 31, 2008.  The year to date increase
within this category can be attributed to two new loans funded during the third
quarter of 2009 totaling approximately $2.7 million.





Heritage
Oaks Bancorp | - 46 -







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 September 30, 2009:





September 30, 2009
                      
                      
                      
                      
                      
                      Percent of
                      
                      
                      
                      
                      
                      SingleUndisbursed
                      
                      
                      Total Bank
                      
                      
                      Percent
                      
                      
                      Bank's Risk
                      
                      
                      Number
                      
                      
                      Largest(dollars in thousands)
                      
                      Balance
                      
                      
                      Commitment
                      
                      
                      Exposure
                      
                      
                      Composition
                      
                      
                      BasedCapital
                      
                      
                      of Loans
                      
                      
                      LoanSingle
      family residential
                      
                      $
                      14,669
                      
                      
                      $
                      8,067
                      
                      
                      $
                      22,736
                      
                      
                      
                      25.6
                      %
                      
                      
                      26.1
                      %
                      
                      
                      29
                      
                      
                      $
                      4,600Single
      family residential - Spec.
                      
                      
                      5,757
                      
                      
                      
                      545
                      
                      
                      
                      6,302
                      
                      
                      
                      7.1
                      %
                      
                      
                      7.2
                      %
                      
                      
                      9
                      
                      
                      
                      2,346Tract
                      
                      
                      2,215
                      
                      
                      
                      -
                      
                      
                      
                      2,215
                      
                      
                      
                      2.5
                      %
                      
                      
                      2.5
                      %
                      
                      
                      10
                      
                      
                      
                      532Multi-family
                      
                      
                      5,575
                      
                      
                      
                      1,909
                      
                      
                      
                      7,484
                      
                      
                      
                      8.4
                      %
                      
                      
                      8.6
                      %
                      
                      
                      4
                      
                      
                      
                      3,584Commercial
                      
                      
                      22,997
                      
                      
                      
                      12,690
                      
                      
                      
                      35,687
                      
                      
                      
                      40.2
                      %
                      
                      
                      41.0
                      %
                      
                      
                      27
                      
                      
                      
                      6,100Hospitality
                      
                      
                      14,252
                      
                      
                      
                      59
                      
                      
                      
                      14,311
                      
                      
                      
                      16.2
                      %
                      
                      
                      16.4
                      %
                      
                      
                      3
                      
                      
                      
                      7,359Total
      construction
                      
                      $
                      65,465
                      
                      
                      $
                      23,270
                      
                      
                      $
                      88,735
                      
                      
                      
                      100.0
                      %
                      
                      
                      101.8
                      %
                      
                      
                      82
                      
                      
                      $
                      24,521





At
September 30, 2009, construction balances represented approximately $65.5
million or 9.2% of total gross loan balances.  This when compared to
the $75.2 million reported at December 31, 2008, represents a decline of
approximately $9.7 million or 12.9%.





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





Year to
date declines in the category of single family residential – spec can be
attributed in large part to the charge off of several loans and their subsequent
movement into OREO status.  For the first nine months of 2009 the Bank
charged-off approximately $2.1 million in such balances and moved approximately
$5.5 million to OREO status.





Declines
in the category of hospitality is attributed in large part to balances moving to
commercial real estate upon completion of underlying projects as well as pay
downs.





At
September 30, 2009 total construction commitments represented approximately
101.8% of the Bank’s total risk based capital.  This when compared to
the 135.9% reported at December 31, 2008, represents a decline of approximately
34.1 percentage points.  The additional capital obtained under the
Company’s participation in the U.S. Treasury’s CPP contributed substantially to
the year to date decline.  Approximately $26.7 million or 40.9% of the
Bank’s construction portfolio was considered owner occupied as of September 30,
2009.





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





Land





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





September 30, 2009
                        
                        
                        
                        
                        
                        Percent of
                        
                        
                        
                        
                        
                        SingleUndisbursed
                        
                        
                        Total Bank
                        
                        
                        Percent
                        
                        
                        Bank's Risk
                        
                        
                        Number
                        
                        
                        Largest(dollars in thousands)
                        
                        Balance
                        
                        
                        Commitment
                        
                        
                        Exposure
                        
                        
                        Composition
                        
                        
                        Based Capital
                        
                        
                        of Loans
                        
                        
                        LoanSingle
      family residential
                        
                        $
                        6,120
                        
                        
                        $
                        41
                        
                        
                        $
                        6,161
                        
                        
                        
                        10.8
                        %
                        
                        
                        7.1
                        %
                        
                        
                        25
                        
                        
                        $
                        1,200Single
      family residential - Spec.
                        
                        
                        2,054
                        
                        
                        
                        -
                        
                        
                        
                        2,054
                        
                        
                        
                        3.6
                        %
                        
                        
                        2.4
                        %
                        
                        
                        8
                        
                        
                        
                        618Tract
                        
                        
                        30,538
                        
                        
                        
                        1,096
                        
                        
                        
                        31,634
                        
                        
                        
                        55.7
                        %
                        
                        
                        36.3
                        %
                        
                        
                        12
                        
                        
                        
                        12,208Multi-family
                        
                        
                        1,512
                        
                        
                        
                        -
                        
                        
                        
                        1,512
                        
                        
                        
                        2.7
                        %
                        
                        
                        1.7
                        %
                        
                        
                        3
                        
                        
                        
                        675Commercial
                        
                        
                        10,314
                        
                        
                        
                        1,019
                        
                        
                        
                        11,333
                        
                        
                        
                        20.0
                        %
                        
                        
                        13.0
                        %
                        
                        
                        19
                        
                        
                        
                        1,500Hospitality
                        
                        
                        4,081
                        
                        
                        
                        -
                        
                        
                        
                        4,081
                        
                        
                        
                        7.2
                        %
                        
                        
                        4.7
                        %
                        
                        
                        4
                        
                        
                        
                        2,340Total
      land
                        
                        $
                        54,619
                        
                        
                        $
                        2,156
                        
                        
                        $
                        56,775
                        
                        
                        
                        100.0
                        %
                        
                        
                        65.2
                        %
                        
                        
                        71
                        
                        
                        $
                        18,541








At
September 30, 2009, land balances represented approximately $54.6 million or
7.7% of total gross loan balances.  When compared to the $61.7 million
reported at December 31, 2008, land balances declined approximately $7.1
million.  The year to date decline can be attributed to the pay down /
payoff of several loans in the aggregate amount of $4.6
million.  Additionally, during the first nine months of the year the
Bank charged-off $2.8 million and  moved approximately $2.3 million in
land balances to OREO, contributing to the year to date decline.





Heritage
Oaks Bancorp | - 47 -





Management’s
Discussion and Analysis





New loans
within this category include five loans to five borrowers in the aggregate
amount of $1.7 million.  The majority of these loans are classified as
land – commercial and land – single family residential as of September 30, 2009
and were made to borrowers within the Bank’s primary market area.





The
single largest loan within this category is for a residential tract development
and carries a balance of approximately $10.7 million at September 30,
2009.    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 is in the process of valuing both the development and
quarry operations separately to create separate purpose
financing.  During the third quarter of 2009, the Bank placed this
loan on non-accrual status resulting from an issue related to the treatment of
an interest reserve.  As a result, the Bank reversed approximately
$0.8 million in interest income related to this loan in the third
quarter.  Upon working with the borrower, Management was able to
collect all the reversed interest and subsequently returned the loan to accruing
status during the month of October 2009.  The Bank will recognize the
$0.8 million interest payment in the fourth quarter of 2009.





At
September 30, 2009 total land commitments represented 65.2% of the Bank’s total
risk based capital.  When compared to the 85.2% reported at December
31, 2008, this represents a decline of approximately 20.0 percentage
points.  The additional capital obtained under the Company’s
participation in the U.S. Treasury’s CPP contributed substantially to the year
to date decline.





At
September 30, 2009 approximately $7.1 million or 13.1% of total land balances
were considered owner occupied.





Installment





At
September 30, 2009, the installment loan balances were approximately $8.9
million.  This, when compared to the $7.9 million reported at December
31, 2008, represents an increase of approximately $1.0
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 September 30, 2009 mortgage correspondent loans (loans held
for sale) totaled approximately $7.8 million.  This when compared to
the $7.9 million reported at December 31, 2008, represents an increase of
approximately $0.1 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
September 30, 2009 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 2009 and the Company has begun to see increases in vacancy rates
in certain retail, industrial and office segments.  The most recent
data available to the Company shows vacancy rates within retail, industrial and
office segments to be approximately 3.0%, 5.4% and 6.1%, respectively as of the
third quarter of 2008.  When compared to levels in the year ago
period, this represents respective increases of approximately 160, 310 and 260
basis points.  The Company realizes that any prolonged and significant
downturn in the national and local economies may further impact the values of
commercial real estate within its market footprint as well as the borrowers to
whom the Bank has extended such credit 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.





Heritage
Oaks Bancorp | -48 -





Management’s
Discussion and Analysis





Although,
the Company’s market footprint has historically enjoyed a more stable level of
economic growth, we are not completely immune to the effects of a slowdown on a
state or national level.  As previously mentioned, with the effects of
a weakened economy placing more pressure on borrowers, the ability of consumers
to satisfy outstanding obligations to the financial sector, as a whole, has
begun to languish.  We believe that within certain areas of our local
economy these more macro level concerns have started to become more
evident.  This has had an impact on the level of and type of loans the
Bank has placed on non-accrual and charged-off during 2008 and into
2009.  Additionally, the Company has devoted considerable resources to
the monitoring of credits within the loan portfolio in order to take any
appropriate steps when and if necessary to mitigate any material adverse impact
the effects of weakened economic conditions may have on the Bank
overall.





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





Allowance
for Loan Losses





At
September 30, 2009 the allowance for loan losses was approximately $15.9 million
compared to the $10.4 million reported at December 31, 2008.  During
the three and nine months ended September 30, 2009, the Bank made provisions to
the allowance for loan losses in the amounts of $9.8 million and $14.6 million,
respectively.  Loans charged-off during the three and nine months
ended September 30, 2009 totaled approximately $5.0 million and $9.1 million,
respectively.  For the three and nine months ended September 30, 2009,
net charge-off to average loans was 0.70% and 1.29%, respectively.  At
September 30, 2009 the allowance for loan losses represented 2.24% of total
gross loans compared to the 1.53% reported at December 31,
2008.  Management believes that as of September 30, 2009, the
allowance for loan losses was sufficient to cover current estimable losses in
the Bank’s loan portfolio.





The Bank
maintains an allowance for loan losses at a level considered by Management to be
adequate to provide for probable incurred losses.  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.





The
specific credit allocation of the allowance is determined through the
measurement of impairment on certain loans that have been identified at each
reporting period as impaired.  Once the amount of impairment on
specific impaired loans has been determined, the Bank typically establishes a
corresponding valuation allowance for such loans.  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.  The loan portfolio is then further segmented by an
internal loan grading system that classifies loans as: pass, special mention,
substandard and doubtful.  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.  Loss rates applied are determined
through an analysis of historical loss rates for each segment of the loan
portfolio.  Finally, 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, 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.





Heritage
Oaks Bancorp | - 49 -





Management’s
Discussion and Analysis





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.  In determining
an appropriate level for the allowance, Management takes into consideration
known relevant internal and external factors that may affect collectability of
specific credits as well as certain pools of loans.  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, may 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.





Non-Performing
Assets





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





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





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.





In regard
to updated collateral valuations, once a loan is identified with sufficient
weakness to merit a downgrade to substandard status, an appraisal of the
underlying collateral is performed and if warranted, a valuation allowance for
such loan is established. For loans on non-accrual, in addition to the action
taken on downgraded credits noted in the previous sentence, an analysis of the
value of the underlying collateral is performed at least quarterly.





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





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 and single family residential speculative
construction. There also appears to be some increasing pressure on commercial
real estate loans, however, the Bank has not experienced significant migration
from performing to non-performing within this category as of this
time.





Heritage
Oaks Bancorp | - 50 -





Management’s
Discussion and Analysis





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





September 30,
                              
                              
                              December 31,(dollars in thousands)
                              
                              2009
                              
                              
                              2008Loans delinquent 90 days or more and still
      accruing
                              
                              $
                              445
                              
                              
                              $
                              348Non-Accruing
      Loans:Commercial
      real estate
                              
                              
                              5,747
                              
                              
                              
                              1,961Residential
      1-4 family
                              
                              
                              1,272
                              
                              
                              
                              265Home
      equity lines of credit
                              
                              
                              320
                              
                              
                              
                              320Commercial
                              
                              
                              5,958
                              
                              
                              
                              7,060Agriculture
                              
                              
                              3,214
                              
                              
                              
                              -Construction
                              
                              
                              3,838
                              
                              
                              
                              5,990Land
                              
                              
                              18,993
                              
                              
                              
                              2,720Installment
                              
                              
                              51
                              
                              
                              
                              11Total non-accruing loans
                              
                              $
                              39,393
                              
                              
                              $
                              18,327Other real estate owned
                              
                              $
                              2,607
                              
                              
                              $
                              1,337Total non-performing assets
                              
                              $
                              42,445
                              
                              
                              $
                              20,012Ratio
      of allowance for credit losses to total gross loans
                              
                              
                              2.24
                              %
                              
                              
                              1.53
                              %Ratio
      of allowance for credit losses to total non-performing
    loans
                              
                              
                              39.84
                              %
                              
                              
                              55.75
                              %Ratio
      of non-performing loans to total gross loans
                              
                              
                              5.61
                              %
                              
                              
                              2.75
                              %Ratio
      of non-performing assets to total assets
                              
                              
                              4.58
                              %
                              
                              
                              2.48
                              %




At
September 30, 2009 the balance of non-accruing loans was approximately $39.4
million or $21.1 million higher than the $18.3 million reported at December 31,
2008.  Notable changes in the balance of non-accruing loans occurred
within the categories of commercial real estate, residential 1-4 family,
commercial and industrial, construction and land.  The significant
increase in non-accruing land balances can be attributed to the previously
disclosed $10.7 million loan that was returned to accrual status during October
2009.  Increases within the non-accruing land category can also be
attributed to five loans to three borrowers.





As
indicated in the table below, the Bank received payments on non-accruing loans
of approximately $2.0 million during the first nine months of 2009, 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 nine months of the year totaled approximately $9.1 million, the
majority of which occurred in the categories of commercial and industrial,
construction and land.   Balances moved to foreclosed collateral
during the first nine months of 2009 totaled approximately $9.7 million, the
majority of which occurred in the construction segment of the
portfolio.  Partially offsetting the increase in non-accruing balances
were two loans totaling approximately $1.3 million that the Bank returned to
accruing status after working with the respective borrowers.





Non-performing
assets totaled approximately $42.4 million at September 30, 2009, approximately
$22.4 million higher than that reported at December 31, 2008.





Heritage
Oaks Bancorp | - 51 -





Management’s
Discussion and Analysis





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





Balance
                        
                        
                        Additions to
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        Transfers
                        
                        
                        BalanceDecember 31,
                        
                        
                        Non-Accruing
                        
                        
                        Net
                        
                        
                        
                        
                        
                        Returns to
                        
                        
                        to Foreclosed
                        
                        
                        September30,(dollars in thousands)
                        
                        2008
                        
                        
                        Balances
                        
                        
                        Paydowns
                        
                        
                        Charge-offs
                        
                        
                        Accrual
                        
                        
                        Collateral
                        
                        
                        2009Real
      Estate SecuredMulti-family
      residential
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        -
                        
                        
                        $
                        -Residential
      1 to 4 family
                        
                        
                        265
                        
                        
                        
                        1,330
                        
                        
                        
                        (19
                        )
                        
                        
                        (304
                        )
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        1,272Home
      equity line of credit
                        
                        
                        320
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        320Commercial
                        
                        
                        1,961
                        
                        
                        
                        4,477
                        
                        
                        
                        (615
                        )
                        
                        
                        (41
                        )
                        
                        
                        -
                        
                        
                        
                        (35
                        )
                        
                        
                        5,747Farmland
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -CommercialCommercial
      and industrial
                        
                        
                        7,060
                        
                        
                        
                        2,758
                        
                        
                        
                        (376
                        )
                        
                        
                        (1,728
                        )
                        
                        
                        (14
                        )
                        
                        
                        (1,742
                        )
                        
                        
                        5,958Agriculture
                        
                        
                        -
                        
                        
                        
                        5,307
                        
                        
                        
                        (184
                        )
                        
                        
                        (1,909
                        )
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        3,214Other
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -ConstructionSingle
      family residential
                        
                        
                        -
                        
                        
                        
                        1,465
                        
                        
                        
                        (380
                        )
                        
                        
                        (145
                        )
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        940Single
      family residential - Spec.
                        
                        
                        5,990
                        
                        
                        
                        3,557
                        
                        
                        
                        -
                        
                        
                        
                        (2,073
                        )
                        
                        
                        (1,250
                        )
                        
                        
                        (5,541
                        )
                        
                        
                        683Tract
                        
                        
                        -
                        
                        
                        
                        2,215
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        2,215Multi-family
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Hospitality
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Commercial
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Land
                        
                        
                        2,720
                        
                        
                        
                        21,715
                        
                        
                        
                        (373
                        )
                        
                        
                        (2,792
                        )
                        
                        
                        -
                        
                        
                        
                        (2,277
                        )
                        
                        
                        18,993Installment
      loans to individuals
                        
                        
                        11
                        
                        
                        
                        272
                        
                        
                        
                        (6
                        )
                        
                        
                        (143
                        )
                        
                        
                        -
                        
                        
                        
                        (83
                        )
                        
                        
                        51All
      other loans
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        -Totals
                        
                        $
                        18,327
                        
                        
                        $
                        43,096
                        
                        
                        $
                        (1,953
                        )
                        
                        $
                        (9,135
                        )
                        
                        $
                        (1,264
                        )
                        
                        $
                        (9,678
                        )
                        
                        $
                        39,393





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





Real
Estate Secured Commercial





Comprising
a considerable portion of balances within this category are seven loans to four
borrowers in the aggregate amount of $4.4 million.  These loans
represented 76.9% of total non-accruing CRE balances and 11.2% of total
non-accruing loans as of September 30, 2009.  These loans are well
secured and the Bank is working with the respective borrowers where possible to
liquidate the collateral.  During the first nine months of 2009, the
Bank received proceeds in the amount of $0.5 million from the sale of collateral
securing one loan as well as approximately $0.1 million in principal pay downs
on several other credits.





Commercial
and Industrial





The
majority of C&I balances can be attributed to one loan with a current book
balance of approximately $3.6 million, comprising 61.1% of total non-accruing
C&I balances and 9.2% of total non-accruing balances as of September 30,
2009.  This loan is secured by property in the Bank’s primary market
area that has a current appraisal received October 13, 2009 that supports the
amount carried on the balance sheet.  Other significant balances
within this category include two loans to two borrowers, totaling approximately
$0.9 million, representing 15.7% of total C&I non-accruing
balances.  The Bank also moved two loans to one borrower in the
aggregate amount of $1.7 million to OREO status during the second quarter of
2009.  These loans are secured by land for commercial development
within the Bank’s primary market.  During the third quarter of 2009,
the Bank received an updated appraisal on this property and as a result wrote it
down by approximately $1.3 million.  Of the $1.7 million in
charge-offs occurring within this segment during 2009, approximately $1.0
million can be attributed to three loans, while $0.7 million can be attributed
to several smaller loans added to non-accruing status during the first nine
months of the year and subsequently charged-off.





Agriculture





The
majority of non-accruing agriculture balances can be attributed to one loan in
the approximate amount of $2.8 million.  During the third quarter of
2009, the Bank charged-off approximately $1.7 million related to this one
loan.  This loan is collateralized by various inventory and business
assets.  The Bank has begun the process to take possession of and
liquidate the underlying collateral.  The loan was made to a borrower
within the Bank’s primary market area.





Heritage
Oaks Bancorp | - 52 -





Management’s
Discussion and Analysis








Construction





A
significant portion of non-accruing balances within this segment of the loan
portfolio can be attributed in large part to eight tract loans to one borrower
totaling approximately $1.3 million or approximately 34.1% of total non-accruing
construction balances.  All eight loans have approved purchase
contracts in place and have been sold under a state assisted low income housing
program and are expected to close in the fourth quarter of
2009.  Other significant non-accruing balances within this segment of
the loan portfolio include three loans to one borrower, totaling approximately
$1.5 million or 40.4% of total non-accruing construction
balances.  These loans are secured by properties within the Bank’s
primary market area.  The Bank is currently working with the borrower
to liquidate the collateral.  During the first nine months of 2009,
the Bank charged off approximately $2.2 million in construction balances, the
majority of which can be attributed to balances the Bank subsequently moved to
OREO status and later sold.





Land





The
majority of balances within this category can be attributed to six loans to four
borrowers totaling approximately $17.9 million.  These loans
represented 94.4% of total non-accruing land balances and 45.5% of all
non-accruing balances.  As previously mentioned, the majority of
non-accruing balances within this category can be attributed to one loan to one
borrower in the amount of $10.7 million that was placed on non-accrual in the
third quarter, but was returned to accruing status following a payment the Bank
received from the borrower of $0.8 million in October 2009.  This loan
was placed on non-accrual during the third quarter related to the treatment of
an interest reserve.





Contributing
further to the year to date increase within this category were five additional
loans the Bank placed on non-accruing status.  The majority of these
loans can be attributed to two loans to one borrower totaling approximately $4.9
million.  Placing these loans on non-accrual status was the result of
additional information obtained regarding the borrower’s financial condition and
Management’s evaluation of the independent review performed on these
credits.  During the third quarter of 2009, the Bank charged-off
approximately $0.7 million related to this particular
relationship.  Additionally, as the result of receiving new appraisals
on property securing two other loans within this category, the Bank charged-off
approximately $0.6 million related to one relationship during the third quarter
of 2009.





Management
is in the process of obtaining updated appraisal information for the collateral
securing the remaining loans and is working with the borrowers to bring about
resolution.  A significant portion of the charge-offs that occurred in
the third quarter of 2009 within this segment of the loan portfolio can be
attributed to the write-downs mentioned in the preceding
paragraph.  Additionally, approximately $0.8 million in land
charge-offs can be attributed to the write-down of one loan which the Bank
subsequently moved to OREO and later sold late in the third quarter of
2009.





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





Other
Real Estate Owned (“OREO”)





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





For the nine months ended(dollars in thousands)
                                  
                                  September 30, 2009Balance
      December 31, 2008
                                  
                                  $
                                  1,337Additions
                                  
                                  
                                  9,595Dispositions
                                  
                                  
                                  (6,876
                                  )Write-downs
                                  
                                  
                                  (1,449
                                  )Balance September 30, 2009
                                  
                                  $
                                  2,607





As of
September 30, 2009, the balance of OREO was approximately $2.6 million, an
increase of approximately $1.3 million from that reported at December 31, 2008
and down approximately $4.1 million from that reported at June 30,
2009.  During the first nine months of 2009, the Bank sold nine
properties, resulting in a reduction in the balance of OREO of approximately
$6.9 million, as represented in the table above.  During the third
quarter of 2009, the Bank sold five properties, previously booked at
approximately $3.9 million.  In connection with these sales, the Bank
recognized aggregate losses of approximately $0.2 million.  For the
first nine month of 2009 losses on the sale of OREO properties totaled
approximately $0.3 million.





Heritage
Oaks Bancorp | - 53 -





Management’s
Discussion and Analysis





Total
Cash and Cash Equivalents





Total
cash and cash equivalents were $63.9 million and $24.6 million at September 30,
2009 and December 31, 2008, respectively. This line item will vary depending on
cash letters from the previous night and actual cash on hand in the
branches.  Additionally, increased deposit balances are reflected in
higher balances of Federal Funds sold.





Investment
Securities and Other Earning Assets





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





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





September 30,
                      
                      
                      December 31,
                      
                      
                      Variance(dollars in thousands)
                      
                      2009
                      
                      
                      2008
                      
                      
                      dollar
                      
                      
                      percentageFederal
      Home Loan Bank stock
                      
                      $
                      5,828
                      
                      
                      $
                      5,123
                      
                      
                      $
                      705
                      
                      
                      
                      13.76
                      %Available
      for sale securities
                      
                      
                      102,871
                      
                      
                      
                      50,762
                      
                      
                      
                      52,109
                      
                      
                      
                      102.65
                      %Federal
      funds sold
                      
                      
                      45,740
                      
                      
                      
                      6,650
                      
                      
                      
                      39,090
                      
                      
                      
                      587.82
                      %Interest bearing deposits other financial
      institutions
                      
                      
                      119
                      
                      
                      
                      119
                      
                      
                      
                      -
                      
                      
                      
                      0.00
                      %Total other earning assets
                      
                      $
                      154,558
                      
                      
                      $
                      62,654
                      
                      
                      $
                      91,904
                      
                      
                      
                      146.68
                      %





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 September 30,
2009, the Bank held approximately $5.8 million in FHLB stock, an increase of
approximately $0.7 million from that reported at December 31,
2008.





Available
for Sale Investment Securities





At
September 30, 2009 the balance of available for sale investment securities was
approximately $102.9 million, $52.1 million or 102.7% higher than that reported
at December 31, 2008.  The change in the balance of the portfolio can
be attributed in large part to purchases the Bank made during the first nine
months of the year in the aggregate amount $76.6 million, sales, calls and
maturities of securities in the aggregate amount of $17.2 million and principal
pay downs totaling approximately $8.4 million.





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





Securities
available-for-sale are carried at fair value, with related unrealized net gains
or losses, net of deferred income taxes, recorded as an adjustment to equity
capital.  At September 30, 2009 the securities portfolio had a net
unrealized loss of approximately $1.0 million and $0.6 million, net of
tax.  This represents a decline in the net unrealized loss position of
approximately $0.8 million and $0.5 million, net of tax, when compared to that
reported at December 31, 2008.  The year to date increase in the fair
value of the securities portfolio can be attributed to, among other things,more rational pricing of
mortgage related securities as well as increases in the values of certain
purchases the Bank made during the first and second quarters of
2009.





Heritage
Oaks Bancorp | - 54 -





Management’s
Discussion and Analysis


At
September 30, 2009, the Bank owned twelve Whole Loan Private Label Mortgage
Backed Securities (“PMBS”) with a principal balance of approximately $23.4
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 the PMBS bonds along with all 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 September 30, 2009, six bonds in the approximate
amount of $14.7 million, have been 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
more credit support or enhancement, the more protection is provided from
possible losses on non-performing collateral and the credit enhancement has
actually increased from the original amount through September 30, 2009 on all
but one bond.  As the Bank receives cash flow on its senior position
and principle is reduced quicker than default losses are applied to the
subordinate positions, the credit enhancement percentage grows.





The Bank
continues to perform extensive analyses on the PMBS bonds in the portfolio.
These investment securities, including the six downgraded bonds mentioned above,
continue to demonstrate cash flows as expected, based on pre-purchase analyses,
and the credit support component of these tranches has actually increased from
the origination date.  As of September 30, 2009, Management does not
believe that there is other than temporary impairment and as such has made no
entry for impairment.





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





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





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





Federal
Funds Sold





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










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 September 30, 2009:





Variance
      Exclusive ofSeptember
      30,
                            
                            
                            December
      31,
                            
                            
                            Variance
                            
                            
                            Volatile Balances(dollars in thousands)
                            
                            2009
                            
                            
                            2008
                            
                            
                            dollar
                            
                            
                            percentage
                            
                            
                            dollar
                            
                            
                            percentageNon-interest
      bearing demand
                            
                            $
                            181,670
                            
                            
                            $
                            147,044
                            
                            
                            $
                            34,626
                            
                            
                            
                            23.55
                            %
                            
                            $
                            17,322
                            
                            
                            
                            11.78
                            %Interest
      bearing demand
                            
                            
                            70,092
                            
                            
                            
                            72,952
                            
                            
                            
                            (2,860
                            )
                            
                            
                            -3.92
                            %
                            
                            
                            15,712
                            
                            
                            
                            21.54
                            %Savings
                            
                            
                            26,088
                            
                            
                            
                            21,835
                            
                            
                            
                            4,253
                            
                            
                            
                            19.48
                            %
                            
                            
                            4,253
                            
                            
                            
                            19.48
                            %Money
      market
                            
                            
                            231,005
                            
                            
                            
                            173,199
                            
                            
                            
                            57,806
                            
                            
                            
                            33.38
                            %
                            
                            
                            71,363
                            
                            
                            
                            41.20
                            %Time deposits
                            
                            
                            227,670
                            
                            
                            
                            139,872
                            
                            
                            
                            87,798
                            
                            
                            
                            62.77
                            %
                            
                            
                            87,798
                            
                            
                            
                            62.77
                            %Total retail deposits
                            
                            
                            736,525
                            
                            
                            
                            554,902
                            
                            
                            
                            181,623
                            
                            
                            
                            32.73
                            %
                            
                            
                            196,448
                            
                            
                            
                            35.40
                            %Brokered
      time deposits
                            
                            
                            15,003
                            
                            
                            
                            20,117
                            
                            
                            
                            (5,114
                            )
                            
                            
                            -25.42
                            %
                            
                            
                            (5,114
                            )
                            
                            
                            -25.42
                            %Brokered money market funds
                            
                            
                            2,001
                            
                            
                            
                            28,502
                            
                            
                            
                            (26,501
                            )
                            
                            
                            -92.98
                            %
                            
                            
                            (26,501
                            )
                            
                            
                            -92.98
                            %Total brokered deposits
                            
                            
                            17,004
                            
                            
                            
                            48,619
                            
                            
                            
                            (31,615
                            )
                            
                            
                            -65.03
                            %
                            
                            
                            (31,615
                            )
                            
                            
                            -65.03
                            %Total deposits
                            
                            $
                            753,529
                            
                            
                            $
                            603,521
                            
                            
                            $
                            150,008
                            
                            
                            
                            24.86
                            %
                            
                            $
                            164,833
                            
                            
                            
                            27.31
                            %





Deposits





During
the first nine months of 2009, the Bank placed considerable emphasis on the
acquisition of additional core deposits.  The focus on this initiative
proved to be successful as the Bank saw core deposit balances (non-interest and
interest bearing demand, savings, money market and time certificate accounts
with balances less than $100 thousand) increase approximately $126.4 million
during the first nine months of 2009 from that reported at December 31, 2008,
with significant increases in non-interest bearing demand, money market and time
certificate of deposit accounts.





In an
effort to rely less on FHLB borrowings and maintain an appropriate mix of
secondary funding, the Bank purchased brokered deposits to assist in the funding
of balance sheet growth and to provide an additional source of
liquidity.  At September 30, 2009, brokered deposit balances totaled
approximately $17.0 million, a decline of approximately $31.6 million from that
reported at December 31, 2008 and a decline $21.5 million from that reported at
June 30, 2009.  Declines in brokered funds can be attributed to the
significant growth in core deposits.





Volatile
Deposits





The Bank
monitors the balance of various accounts that it considers to be volatile for a
variety of reasons and provides this data to the Board of Directors on a regular
basis.  Accounts may be added to or removed from the volatile
liability dependency report when, based on Management’s judgment, it is
determined that these funds are not suitable for any form of long term
investment or that the risk associated with these funds leaving the Bank has
become minimal.  Typically a material change in the balances of these
accounts is reflected in the balance of Federal Funds sold.  At
September 30, 2009, the aggregate balance of deposits the Bank considers to be
volatile was approximately $46.5 million or $15.0 million lower than that
reported at December 31, 2008.





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





Percent
      of
                        
                        
                        
                        
                        
                        Percent
      ofSeptember
      30,
                        
                        
                        Total
                        
                        
                        December
      31,
                        
                        
                        Total
                        
                        
                        Dollar(dollars in thousands)
                        
                        2009
                        
                        
                        Deposits
                        
                        
                        2008
                        
                        
                        Deposits
                        
                        
                        VarianceNon-interest
      bearing demand
                        
                        $
                        28,497
                        
                        
                        
                        3.8
                        %
                        
                        $
                        11,193
                        
                        
                        
                        1.9
                        %
                        
                        $
                        17,304Interest
      bearing demand
                        
                        
                        3,123
                        
                        
                        
                        0.4
                        %
                        
                        
                        21,695
                        
                        
                        
                        3.6
                        %
                        
                        
                        (18,572
                        )Savings
                        
                        
                        -
                        
                        
                        
                        0.0
                        %
                        
                        
                        196
                        
                        
                        
                        0.0
                        %
                        
                        
                        (196
                        )Money market deposits
                        
                        
                        14,925
                        
                        
                        
                        2.0
                        %
                        
                        
                        28,482
                        
                        
                        
                        4.7
                        %
                        
                        
                        (13,557
                        )Total volatile deposits
                        
                        $
                        46,545
                        
                        
                        
                        6.2
                        %
                        
                        $
                        61,566
                        
                        
                        
                        10.2
                        %
                        
                        $
                        (15,021
                        )















The year
to date decline in balances the Bank considers to be volatile can be attributed
in large part to declines in volatile interest bearing demand balances of
approximately $18.6 million.  The year to date decline within this
category is the result of two relationships leaving the Bank, the majority of
which are considered public funds.  These declines were partially
offset by a dramatic increase in volatile non-interest bearing demand
balances.  The customers that hold these deposits engage in mortgage
related activities.  As more and more home owners have moved to
re-finance existing mortgages, given the current rate environment, deposit
balances related to these customers have increased.  Management and
the Board of Directors are aware that as conditions in the market change these
relationships will be impacted.





Borrowed
Funds





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





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





Amount
                            
                            
                            Interest
                            
                            MaturityBorrowed
                            
                            
                            Rate
                            
                            Variable/Fixed
                            
                            Date$
                            55,000
                            
                            
                            
                            0.10
                            %
                            Variable
                            
                            Open10,000
                            
                            
                            
                            2.89
                            %
                            Fixed
                            
                            9/16/10$
                            65,000
                            
                            
                            
                            0.53
                            %




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





During
the third quarter of 2009, the Company was advised that the ability to drawn on
the  promissory note with Pacific Coast Bankers Bank (“PCBB”) for a
revolving line of credit in the amount of $3.5 million was suspended. The
Company was informed that PCBB was not suspending the Company’s line due to any
action or circumstance surrounding the condition of the Company itself, but
rather PCBB  was suspending all such similar lines of credit that they
had issued to financial institutions due to overall uncertainty in the economic
environment. The Company did not deem this to be of a material nature as the
line was not used during 2008 nor was it used during the first nine months of
2009. Due to lack of use, the Company was not planning on renewing the loan at
maturity in October 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
September 30, 2009, the balance of stockholders’ equity was approximately $87.8
million.  This, when compared to the $70.0 million at December 31,
2008, represents an increase of approximately $17.8 million. The year to date
change in capital is due primarily to $21.0 million in Senior Preferred Stock
the Company issued to the U.S. Treasury as part of its participation in the
CPP.   Additionally, the year to date change is also attributed
to net losses of $3.6 million, the impact of year-to-date share-based
compensation expense in the amount of $0.3 million, dividends paid on Senior
Preferred stock in the amount of $0.4 million, proceeds from the exercise of
options in the amount of $46 thousand and a decline in the balance of
accumulated other comprehensive loss in the amount of $0.5 million.















Senior
Preferred Stock





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





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





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





Dividends





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





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





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





Trust
Preferred Securities





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





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





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















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





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





Amount
                                
                                
                                Current
                                
                                Issue
                                
                                Scheduled
                                
                                Call(dollars
      in thousands)
                                
                                Issued
                                
                                
                                Rate
                                
                                Date
                                
                                Maturity
                                
                                Date
                                
                                Rate
      TypeHeritage
      Oaks Capital Trust II
                                
                                $
                                8,248
                                
                                
                                
                                2.32
                                %
                                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
                                
                                
                                
                                4.08
                                %





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





Pursuant
to U.S. GAAP, Under 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
September 30, 2009, the Company included $13.0 million of the net junior
subordinated debt in its Tier I Capital for regulatory capital
purposes.





At
September 30, 2009, the Company had sufficient cash to service the $13.4 million
in junior subordinated debenture interest payments for approximately 9 years
without dividends from subsidiaries. The Bank’s capacity to provide cash to the
Company, while remaining “well-capitalized,” was approximately $8.8 million at
September 30, 2009.





Regulatory
Capital Requirements





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





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















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





Regulatory
      Standard
                
                
                September
      30, 2009
                
                
                September
      30, 2008Adequately
                
                
                Well
                
                
                Heritage
      Oaks
                
                
                Heritage
      OaksRatio
                
                Capitalized
                
                
                Capitalized
                
                
                Bancorp
                
                
                Bank
                
                
                Bancorp
                
                
                BankLeverage
      ratio
                
                
                4.00
                %
                
                
                5.00
                %
                
                
                9.30
                %
                
                
                8.76
                %
                
                
                9.01
                %
                
                
                8.78
                %Tier
      I capital to risk weighted assets
                
                
                4.00
                %
                
                
                6.00
                %
                
                
                10.52
                %
                
                
                9.86
                %
                
                
                9.67
                %
                
                
                9.41
                %Total
      risk based capital to risk weighted assets
                
                
                8.00
                %
                
                
                10.00
                %
                
                
                11.78
                %
                
                
                11.12
                %
                
                
                10.92
                %
                
                
                10.66
                %





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





Liquidity





The
objective of liquidity management is to ensure the continuous availability of
funds to meet the demands of depositors, investors and
borrowers.  Asset liquidity is primarily derived from loan payments
and the maturity of other earning assets.  Liquidity from liabilities
is obtained primarily from the receipt of new deposits.  The Bank’s
Asset Liability Committee (“ALCO”) is responsible for managing the on and
off-balance sheet commitments to meet the needs of customers while achieving the
Bank’s financial objectives.  ALCO meets regularly to assess the
projected funding requirements by reviewing historical funding patterns, current
and forecasted economic conditions and individual customer funding
needs.  Deposits generated from the Bank’s customers serve as the
primary source of liquidity.  The Bank has credit arrangements with
correspondent banks that serve as a secondary liquidity source.  At
September 30, 2009, these credit lines totaled $35.0 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
$117.7 million at September 30, 2009. This borrowing capacity is subject to
increased discounts on specific collateral as the result of market valuations
and as such, as of November 6, 2009, the available borrowing capacity was
reduced to approximately $61.5 million.  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.





The Bank
manages liquidity by maintaining a majority of the investment portfolio in
Federal Funds sold and other liquid investments.  Most of
these  investments include obligations of state and political
subdivisions (municipal bonds) and mortgage related securities that provide a
relatively steady stream of cash flows.  As of September 30, 2009, the
Company believes investments in the portfolio can be liquidated at their current
fair values in the event they are needed to provide liquidity.  The
ratio of liquid assets not pledged for collateral and other purposes to deposits
and other liabilities was 19.65% at September 30, 2009 compared to 6.79% at
December 31, 2008.   At September 30, 2009, the Bank was within
its internal guideline for liquidity.  The ratio of net loans to
deposits (“LTD”), another key liquidity ratio, was 91.9% at September 30, 2009
compared to 110.7% at December 31, 2008 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 10 to the Company’s Consolidated Financial Statements
under Item 8 of Part II of the Company’s December 31, 2008 Annual Report filed
on Form 10-K.





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





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










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 September 30,
2009 balances indicate that the net interest income at risk over a one year time
horizon for a 1% and 2% rate increase and decrease is acceptable and within
policy guidelines at this time.





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





Rate Shock Scenarios(dollars in thousands)
                  
                  
                  -200bp
                  
                  
                  
                  -100bp
                  
                  
                  Base
                  
                  
                  
                  +100bp
                  
                  
                  
                  +200bpNet
      interest income (NII)
                  
                  $
                  40,942
                  
                  
                  $
                  41,976
                  
                  
                  $
                  42,529
                  
                  
                  $
                  43,220
                  
                  
                  $
                  44,114$
      Change from base
                  
                  $
                  (1,587
                  )
                  
                  $
                  (553
                  )
                  
                  $
                  -
                  
                  
                  $
                  691
                  
                  
                  $
                  1,585%
      Change from base
                  
                  
                  -3.73
                  %
                  
                  
                  -1.30
                  %
                  
                  
                  0.00
                  %
                  
                  
                  1.62
                  %
                  
                  
                  3.73
                  %





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.










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





(dollars
      in thousands)Percent
      ofRate Type
                        
                        Balance
                        
                        
                        TotalVariable
      - daily
                        
                        $
                        280,494
                        
                        
                        
                        39.5
                        %Variable
      other than daily
                        
                        
                        280,813
                        
                        
                        
                        39.6
                        %Fixed rate
                        
                        
                        148,560
                        
                        
                        
                        20.9
                        %Total gross loans
                        
                        $
                        709,867
                        
                        
                        
                        100.0
                        %





The table
above identifies approximately 39.5% of the loan portfolio that will re-price
immediately in a changing rate environment.  At September 30, 2009,
approximately $561.3 million or 79.1% of the Bank’s loan portfolio is considered
variable.





(dollars
      in thousands)Percent
      ofRe-Pricing
                        
                        Balance
                        
                        
                        Total<
      1 Year
                        
                        $
                        401,042
                        
                        
                        
                        56.4
                        %1-3
      Years
                        
                        
                        174,367
                        
                        
                        
                        24.6
                        %3-5
      Years
                        
                        
                        82,214
                        
                        
                        
                        11.6
                        %> 5 Years
                        
                        
                        52,244
                        
                        
                        
                        7.4
                        %Total gross loans
                        
                        $
                        709,867
                        
                        
                        
                        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 September 30, 2009:





Move in Prime Rate (bps)(dollars in thousands)
                        
                        
                        +200
                        
                        
                        
                        +250
                        
                        
                        
                        +300
                        
                        
                        
                        +350Variable
      daily
                        
                        $
                        660
                        
                        
                        $
                        17,488
                        
                        
                        $
                        51,095
                        
                        
                        $
                        120,055Variable other than daily
                        
                        
                        2,605
                        
                        
                        
                        5,433
                        
                        
                        
                        50,218
                        
                        
                        
                        121,007Cumulative total variable at
      floor
                        
                        $
                        3,265
                        
                        
                        $
                        22,921
                        
                        
                        $
                        101,313
                        
                        
                        $
                        241,062





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





Item
4.  Controls and Procedures





Evaluation
of Disclosure Controls and Procedures





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










Changes
in Internal Control Over Financial Reporting





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





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





Part
II.  Other Information





Item
1.  Legal Proceedings





The 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 September 30,
2009.





Item
1A.  Risk Factors





The
following represents material changes in risk factors from that disclosed in the
Company’s 2008 Annual Report filed on Form 10-K:





We
Cannot Accurately Predict the Effect of the Current Economic Downturn on Our
Future Results of Operations or Market Price of Our Stock





The
national economy and the financial services sector in particular, are currently
facing challenges of a scope unprecedented in recent history. We cannot
accurately predict the severity or duration of the current economic downturn,
which has adversely impacted the markets we serve. Any further deterioration in
the economies of the nation as a whole or in our markets would have an adverse
effect, which could be material, on our business, financial condition, results
of operations and prospects, and could also cause the market price of our stock
to decline.










We
Are Subject to Various Regulatory Requirements and Expect to Be Subject to
Future Regulatory Restrictions and Enforcement Actions





In light
of the current challenging operating environment, along with our elevated level
of non-performing assets, delinquencies, and adversely classified assets, we are
subject to increased regulatory scrutiny, and expect to become subject to
potential enforcement actions. Such enforcement actions could place limitations
on our business and adversely affect our ability to implement our business
plans, including our growth strategy. Even though the Bank remains
well-capitalized, the regulatory agencies have the authority to restrict our
operations to those consistent with adequately capitalized institutions. For
example, if the regulatory agencies were to impose such a restriction, we would
likely have limitations on our lending activities. The regulatory agencies also
have the power to limit the rates paid by the Bank to attract retail deposits in
its local markets. We also may be required to reduce our levels of
non-performing assets within specified time frames. These time frames might not
necessarily result in maximizing the price that might otherwise be received for
the underlying properties. In addition, if such restrictions were also imposed
upon other institutions that operate in the Bank’s markets, multiple
institutions disposing of properties at the same time could further diminish the
potential proceeds received from the sale of these properties. If any of these
or other additional restrictions are placed on us, it would limit the resources
currently available to us as a well-capitalized institution.





In this
regard, the FDIC recently completed its regularly scheduled examination of the
Bank. Based on discussions with the FDIC following the examination, we presently
expect to receive a formal agreement or enforcement order from the FDIC
requiring us to take certain steps to further strengthen the Bank, such as
reducing the level of classified assets, increasing capital levels, and
addressing other criticisms from the examination. We already are developing
strategies and taking actions to address such issues.





Our
Level of Classified Assets Expose Us to Increased Lending Risk. Further, if Our
Allowance for Loan Losses is Insufficient to Absorb Losses in Our Loan
Portfolio, Our Earnings Could Decrease





At
September 30, 2009, loans that we have categorized as doubtful, substandard or
special mention totaled $101.3 million, representing 14.2% of total loans. If
these loans do not perform according to their terms and the collateral is
insufficient to pay any remaining loan balance, we may experience loan losses,
which could have a material effect on our operating results. Like all financial
institutions, we maintain an allowance for loan losses to provide for loans in
our portfolio that may not be repaid in their entirety. At September 30, 2009,
our allowance for loan losses totaled $15.9 million, which represented 2.24% of
total loans and 39.84% of non-performing loans. We believe that our allowance
for loan losses is maintained at a level adequate to absorb probable losses
inherent in our loan portfolio as of the corresponding balance sheet date.
However, our allowance for loan losses may not be sufficient to cover actual
loan losses, and future provisions for loan losses could materially adversely
affect our operating results. We make various assumptions and judgments about
the collectability of our loan portfolio, including the creditworthiness of our
borrowers and their probability of making payment, as well as the value of real
estate and other assets serving as collateral for the repayment of many of our
loans. In determining the amount of the allowance for loan losses, significant
factors we consider include loss experience in particular segments of the
portfolio, trends and absolute levels of classified loans, trends and absolute
levels in delinquent loans, trends in risk ratings, trends in industry
charge-offs by particular segments and changes in existing general economic and
business conditions affecting our lending areas and the national economy. If our
assumptions are incorrect, our allowance for loan losses may be insufficient to
cover losses inherent in our loan portfolio, resulting in additions to our
allowance. Material additions to our allowance could materially decrease our net
income. Our regulators, as an integral part of their examination process,
periodically review our allowance for loan losses and may require us to increase
our allowance for loan losses by recognizing additional provisions for loan
losses charged to expense, or to decrease our allowance for loan losses by
recognizing loan charge-offs, net of recoveries. Any such additional provisions
for loan losses or charge-offs, as required by these regulatory agencies, could
have a material adverse effect on our financial condition and results of
operations.





The
Unseasoned Nature Of A Large Portion Of Our Commercial Real Estate And
Commercial And Industrial Loan Portfolios May Result In Changes In Estimating
Collectability, Which May Lead To Additional Provisions Or Charge-Offs, Which
Could Hurt Our Profits





Our
commercial real estate and commercial and construction loan portfolios have
increased $229.5 million or 58.5% from the end of 2006 through September 30,
2009. Accordingly, much of these loan portfolios are unseasoned. These loans
also have not been subjected to continued declining and unfavorable economic
conditions. As a result, it may be difficult to predict the future performance
of this part of our loan portfolio. These loans may have delinquency or
charge-off levels above our historical experience, which could adversely affect
our future performance. Further, these types of loans generally have larger
balances and involve a greater risk than one- to four-family residential
mortgage loans. Accordingly, if we make any errors in judgment in the
collectability of our commercial real estate and commercial and industrial
loans, any resulting charge-offs may be larger on a per loan basis than those
incurred historically with our residential mortgage loan or consumer loan
portfolios.










Liquidity
Risk Could Impair Our Ability to Fund Operations and Jeopardize Our Financial
Condition





Liquidity
is essential to our business. An inability to raise funds through deposits,
borrowings, the sale of loans and other sources could have a material adverse
effect on our liquidity. Our access to funding sources in amounts adequate to
finance our activities could be impaired by factors that affect us specifically
or the financial services industry in general. Factors that could detrimentally
impact our access to liquidity sources include a decrease in the level of our
business activity due to a market downturn or adverse regulatory action against
us. Additionally, we regularly monitor certain larger deposit relationships that
we determine are not suitable for any form of long-term investment or that
possess a higher risk of leaving us. At September 30, 2009, these volatile
deposits totaled $46.5 million or 6.2% of total deposits. Our ability to acquire
deposits or borrow could also be impaired by factors that are not specific to
us, such as a severe disruption of the financial markets or negative views and
expectations about the prospects for the financial services industry in
general.





We
Depend On Cash Dividends From Our Subsidiary Bank To Meet Our Cash Obligations
and a Failure to Receive them Could Impair Our Ability to Fulfill Our
Obligations





As a
holding company, dividends from our subsidiary bank provide a substantial
portion of our cash flow used to service the interest payments on our trust
preferred securities, our preferred stock and other obligations, including any
cash dividends. Various statutory provisions restrict the amount of dividends
our subsidiary bank can pay to us without regulatory approval.





Because
of Our Participation in the Troubled Asset Relief Program (‘‘TARP’’), We Are
Subject to Several Restrictions, Including Restrictions on Compensation Paid to
Our Executives





Certain
standards for executive compensation and corporate governance apply to us for
the period during which the U.S. Treasury holds an equity position in us. These
standards generally apply to our Chief Executive Officer, Chief Financial
Officer and the three next most highly compensated senior executive officers.
The standards include, among other things, (1) ensuring that incentive
compensation for senior executives does not encourage unnecessary and excessive
risks that threaten the value of the financial institution; (2) required
clawback of any bonus or incentive compensation paid to a senior executive based
on statements of earnings, gains or other criteria that are later proven to be
materially inaccurate; (3) prohibition on making golden parachute payments to
senior executives; and (4) agreement not to deduct for tax purposes, executive
compensation in excess of $500,000 for each senior executive. In particular, the
change to the deductibility limit on executive compensation may increase the
overall cost of our compensation programs in future periods. Pursuant to the
American Recovery and Reinvestment Act of 2009 (the ‘‘Stimulus Bill’’), more
commonly known as the economic stimulus recovery package, further compensation
restrictions, including significant limitations on incentive compensation, have
been imposed on our senior executive officers and most highly compensated
employees. Such restrictions and any future restrictions on executive
compensation, which may be adopted, could adversely affect our ability to hire
and retain senior executive officers.





Declines
in Asset Values May Result in Impairment Charges and Adversely Affect the Value
of Our Investments, Financial Performance and Capital





We
maintain an investment portfolio that includes, but is not limited to,
mortgage-backed securities. The market value of investments in our portfolio has
become increasingly volatile over the past year. The market value of investments
may be affected by factors other than the underlying performance of the servicer
of the securities or the mortgages underlying the securities, such as ratings
downgrades, adverse changes in the business climate and a lack of liquidity in
the secondary market for certain investment securities. On a monthly basis, we
evaluate investments and other assets for impairment indicators. We may be
required to record impairment charges if our investments suffer a decline in
value that is considered other-than-temporary. If we determine that a
significant impairment has occurred, we would be required to charge against
earnings the credit-related portion of the other-than-temporary impairment,
which could have a material adverse effect on our results of operations in the
periods in which the write-offs occur.










The
Recession and Changes in Domestic and Foreign Financial Markets Have Adversely
Affected Our Industry and May Have a Material Negative Impact on Our Results of
Operations and Financial Condition





Economic
indices have shown that since the fourth quarter of 2007, the United States
economy has been in a recession. This has been reflected in significant business
failures and job losses. Further, dramatic declines in the housing market, with
decreasing home prices and increasing delinquencies and foreclosures, have
negatively impacted the credit performance of mortgage and construction loans
and resulted in significant write-downs of assets by many financial
institutions. General downward economic trends, reduced availability of
commercial credit and increased unemployment, have negatively impacted the
performance of commercial and consumer credit resulting in additional
write-downs. Concerns over the stability of the financial markets and the
economy have resulted in decreased lending by financial institutions to their
customers and to each other. This market turmoil and tightening of credit has
led to increased commercial and consumer delinquencies, lack of customer
confidence, increased market volatility and widespread reduction in general
business activity. Financial institutions have experienced decreased access to
deposits and borrowings. The resulting economic pressure on consumers and
businesses and the lack of confidence in the financial markets may adversely
affect our business, financial condition, results of operations and stock price.
We do not expect that the difficult conditions in the financial markets are
likely to improve in the near future. A worsening of these conditions would
likely exacerbate the adverse effects of these difficult market conditions on us
and others in the financial institutions industry. In particular, we may face
the following risks in connection with these events:





• We
potentially face increased regulation of our industry, compliance with which may
increase our costs and limit our ability to pursue business
opportunities.





• The
process we use to estimate losses inherent in our credit exposure requires
difficult, subjective and complex judgments, including forecasts of economic
conditions and how these economic conditions might impair the ability of our
borrowers to repay their loans. The level of uncertainty concerning economic
conditions may adversely affect the accuracy of our estimates, which may, in
turn, impact the reliability of the process.





• The
value of the portfolio of investment securities that we hold may be aversely
affected.





• We may
be required to pay significantly higher FDIC premiums because market
developments have significantly depleted the insurance fund of the FDIC and
reduced the ratio of reserves to insured deposits.





If
current levels of market disruption and volatility continue or worsen, there can
be no assurance that we will not experience an adverse effect, which may be
material, on our business, financial condition and results of
operations.





The
Terms of Our Outstanding Series A Preferred Stock Limit Our Ability to Pay
Dividends on and Repurchase Our Common Stock





The
Purchase Agreement between us and the U.S Treasury provides that before the
earlier of (1) March 20, 2012 and (2) the date on which all of the shares of the
preferred stock have been redeemed by us or transferred by the U.S. Treasury to
third parties, we may not, without consent of the U.S. Treasury, (a) increase
the quarterly cash dividend on our common stock above $0.08 per share, the
amount of the last quarterly cash dividend per share declared prior to October
14, 2008 or (b) subject to limited exceptions, redeem, repurchase or otherwise
acquire shares of our common stock or preferred stock other than the preferred
stock. In addition, we are unable to pay any dividends on our common stock
unless we are current in our dividend payments on the preferred stock. These
restrictions, together with the potentially dilutive impact of the warrant
issued to the U.S. Treasury, could have a negative effect on the value of our
common stock.





Our
Outstanding Preferred Stock Impacts Net Income Available to Our Common
Stockholders and Earnings Per Common Share and the Warrant Issued to the U.S.
Treasury As Well As Other Potential Issuances of Equity Securities May be
Dilutive to Holders of Our Common Stock





The
dividends declared and the accretion on our outstanding preferred stock will
reduce the net income available to common stockholders and our earnings per
common share. The preferred stock will also receive preferential treatment in
the event of our liquidation, dissolution or winding-up. Additionally, the
ownership interest of the existing holders of our common stock will be diluted
to the extent the warrant issued to the U.S. Treasury is exercised. The shares
of common stock underlying the warrant represent approximately 7.9% of the
shares of our common stock outstanding as of September 30, 2009 (including the
shares issuable upon exercise of the warrant in total shares outstanding).
Although the U.S. Treasury has agreed not to vote any of the shares of common
stock it receives upon exercise of the warrant, a transferee of any portion of
the warrant or of any shares of common stock acquired upon exercise of the
warrant is not bound by this restriction. In addition, to the extent options to
purchase common stock under our employee and director stock option plans are
exercised, holders of our common stock will incur additional dilution. Further,
if we sell additional equity or convertible debt securities, such sales could
result in increased dilution to our shareholders.










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





Unregistered
Sale of Equity Securities





None.





Purchases
of Equity Securities





None.





Item
3.  Defaults upon Senior Securities





None.





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





None.





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 2002





Exhibit
      (31.2)
            Certification
      of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002





Exhibit
      (32.1)
            Certification
      of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002





Exhibit
      (32.2)
            Certification
      of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002










Signatures





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





Heritage
Oaks Bancorp





Date:
November 9, 2009





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