UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549





FORM
10-Q





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


For
      the quarterly period ended March 31,
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 o     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 May 1, 2009 there
were 7,751,766 shares outstanding of the Registrant’s common stock.













Heritage Oaks Bancorp and
Subsidiaries|Table of Contents





PagePart
      I.  Financial InformationItem
      1.  Consolidated Financial Statements (un-audited, except for
      Balance Sheet as of 12/31/2008)
                3Consolidated
      Balance Sheets
                4Consolidated
      Income Statements
                5Consolidated
      Statements of Stockholders' Equity
                6Consolidated
      Statements of Comprehensive Income
                7Consolidated
      Statements of Cash Flows
                8Notes
      to Consolidated Financial StatementsNote
      1.  Consolidated Financial Statements
                9Note
      2.  Investment Securities
                9Note
      3.  Loans and the Allowance for Loan Losses
                10Note
      4.  Earnings Per Share
                11Note
      5.  Recent Accounting Pronouncements
                12Note
      6.  Share-Based Compensation
                14Note
      7.  Fair Value of Financial Instruments
                17Note
      8.  Preferred Stock
                19Note
      9.  Reclassifications
                20Forward
      Looking Statements
                21Item
      2.  Management's Discussion and Analysis of Financial Condition
      and Results of Operations
                22The
      Company
                22Where
      You Can Find More Information
                22Executive
      Summary
                23Recent
      Developments
                25Dividends
      and Stock Repurchases
                25Selected
      Financial Data
                26Local
      Economy
                26Critical
      Accounting Policies
                27Results
      of Operations
                29Net
      Interest Income and Margin
                29Non-Interest
      Income
                32Non-Interest
      Expenses
                33Provision
      for Income Taxes
                34Provision
      for Loan Losses
                34Financial
      Condition Analysis
                37Loans
                37Non-Performing
      Assets
                43Cash
      and Cash Equivalents
                45Investment
      Securities and Other Earning Assets
                46Deposits
      and Borrowed Funds
                47Capital
                49Liquidity
                52Inflation
                53Off-Balance
      Sheet Arrangements
                53Item
      3.  Quantative and Qualitative Disclosure About Market
      Risk
                54Item
      4.  Controls and Procedures
                55Part
      II.  Other InformationItem
      1.  Legal Proceedings
                56Item
      1A.  Risk Factors
                56Item
      2.  Unregistered Sales of Equity Securities and Use of
      Proceeds
                56Item
      3.  Defaults upon Senior Securities
                57Item
      4.  Submission of Matters to a Vote of Security
      Holders
                57Item
      5.  Other Information
                57Item
      6.  Exhibits
                58Signatures
                59





- 2
-





Part
I.  Financial Information





Item
1. Consolidated Financial Statements





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





- 3
-





Heritage Oaks
Bancorp


and
Subsidiaries


Consolidated Balance
Sheets





(audited)March 31,
                                  
                                  
                                  December 31,(dollars
      in thousands except per share data)
                                  
                                  2009
                                  
                                  
                                  2008AssetsCash
      and due from banks
                                  
                                  $
                                  16,553
                                  
                                  
                                  $
                                  17,921Federal
      funds sold
                                  
                                  
                                  44,020
                                  
                                  
                                  
                                  6,650Total
      cash and cash equivalents
                                  
                                  
                                  60,573
                                  
                                  
                                  
                                  24,571Interest
      bearing deposits with other banks
                                  
                                  
                                  119
                                  
                                  
                                  
                                  119Securities
      available for sale
                                  
                                  
                                  62,601
                                  
                                  
                                  
                                  50,762Federal
      Home Loan Bank stock, at cost
                                  
                                  
                                  5,828
                                  
                                  
                                  
                                  5,123Loans
      held for sale
                                  
                                  
                                  13,806
                                  
                                  
                                  
                                  7,939Loans,
      net of deferred fees of $1,555 and $1,701 and allowance for loan
      lossof
      $10,429 and $10,412 at March 31, 2009 and December 31, 2008,
      respectively
                                  
                                  
                                  679,657
                                  
                                  
                                  
                                  668,034Property,
      premises and equipment, net
                                  
                                  
                                  6,838
                                  
                                  
                                  
                                  6,827Deferred
      tax assets
                                  
                                  
                                  8,115
                                  
                                  
                                  
                                  7,708Bank
      owned life insurance
                                  
                                  
                                  10,842
                                  
                                  
                                  
                                  10,737Goodwill
                                  
                                  
                                  11,049
                                  
                                  
                                  
                                  11,049Core
      deposit intangible
                                  
                                  
                                  3,428
                                  
                                  
                                  
                                  3,691Other
      real estate owned
                                  
                                  
                                  2,893
                                  
                                  
                                  
                                  1,337Other
      assets
                                  
                                  
                                  6,599
                                  
                                  
                                  
                                  7,691Total
      assets
                                  
                                  $
                                  872,348
                                  
                                  
                                  $
                                  805,588LiabilitiesDeposits:Demand,
      non-interest bearing
                                  
                                  $
                                  164,320
                                  
                                  
                                  $
                                  147,044Savings,
      NOW, and money market deposits
                                  
                                  
                                  303,323
                                  
                                  
                                  
                                  296,488Time
      deposits of $100 or more
                                  
                                  
                                  100,369
                                  
                                  
                                  
                                  75,111Time
      deposits under $100
                                  
                                  
                                  96,809
                                  
                                  
                                  
                                  84,878Total
      deposits
                                  
                                  
                                  664,821
                                  
                                  
                                  
                                  603,521Short
      term FHLB borrowing
                                  
                                  
                                  85,000
                                  
                                  
                                  
                                  99,000Long
      term FHLB borrowing
                                  
                                  
                                  10,000
                                  
                                  
                                  
                                  10,000Securities
      sold under agreement to repurchase
                                  
                                  
                                  -
                                  
                                  
                                  
                                  2,796Junior
      subordinated debentures
                                  
                                  
                                  13,403
                                  
                                  
                                  
                                  13,403Other
      liabilities
                                  
                                  
                                  7,491
                                  
                                  
                                  
                                  6,836Total
      liabilities
                                  
                                  
                                  780,715
                                  
                                  
                                  
                                  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 March 31,
      2009 and December 31, 2008, respectively.
                                  
                                  
                                  19,163
                                  
                                  
                                  
                                  -Common
      stock, no par value; 20,000,000 shares authorized, issued
      and  outstanding 7,751,766 and 7,753,078 as of March 31, 2009
      and December 31, 2008, respectively.
                                  
                                  
                                  48,649
                                  
                                  
                                  
                                  48,649Additional
      paid in capital
                                  
                                  
                                  2,993
                                  
                                  
                                  
                                  1,055Retained
      earnings
                                  
                                  
                                  22,511
                                  
                                  
                                  
                                  21,420Accumulated
      other comprehensive loss, net of tax benefit of $1,176 and
      $763  as of March 31, 2009 and December 31, 2008,
      respectively.
                                  
                                  
                                  (1,683
                                  )
                                  
                                  
                                  (1,092
                                  )Total
      stockholders' equity
                                  
                                  
                                  91,633
                                  
                                  
                                  
                                  70,032Total
      liabilities and stockholders' equity
                                  
                                  $
                                  872,348
                                  
                                  
                                  $
                                  805,588





See notes to condensed consolidated
financial statements.





- 4
-





Heritage Oaks
Bancorp


and
Subsidiaries


Consolidated Statements of
Income





For
      the three monthsended
      March 31,(dollars
      in thousands except per share data)
                        
                        2009
                        
                        
                        2008Interest
      IncomeInterest
      and fees on loans
                        
                        $
                        11,147
                        
                        
                        $
                        12,091Interest
      on investment securitiesObligations
      of U.S. government agencies
                        
                        
                        548
                        
                        
                        
                        421Obligations
      of state and political subdivisions
                        
                        
                        186
                        
                        
                        
                        183Interest
      on time deposits with other banks
                        
                        
                        1
                        
                        
                        
                        3Interest
      on federal funds sold
                        
                        
                        7
                        
                        
                        
                        67Interest
      on other securities
                        
                        
                        7
                        
                        
                        
                        52Total
      interest income
                        
                        
                        11,896
                        
                        
                        
                        12,817Interest
      ExpenseInterest
      on savings, NOW and money market deposits
                        
                        
                        817
                        
                        
                        
                        1,506Interest
      on time deposits in denominations of $100 or more
                        
                        
                        544
                        
                        
                        
                        680Interest
      on time deposits under $100
                        
                        
                        564
                        
                        
                        
                        900Other
      borrowings
                        
                        
                        404
                        
                        
                        
                        611Total
      interest expense
                        
                        
                        2,329
                        
                        
                        
                        3,697Net
      interest income before provision for possible loan losses
                        
                        
                        9,567
                        
                        
                        
                        9,120Provision
      for possible loan losses
                        
                        
                        2,110
                        
                        
                        
                        240Net
      interest income after provision for possible loan losses
                        
                        
                        7,457
                        
                        
                        
                        8,880Non-Interest
      IncomeFees
      and service charges
                        
                        
                        712
                        
                        
                        
                        772Gain
      on sale of investment securities
                        
                        
                        122
                        
                        
                        
                        -Loss
      on sale of OREO
                        
                        
                        (27
                        )
                        
                        
                        -Other
                        
                        
                        853
                        
                        
                        
                        667Total
      non-interest income
                        
                        
                        1,660
                        
                        
                        
                        1,439Non-Interest
      ExpensesSalaries
      and employee benefits
                        
                        
                        3,803
                        
                        
                        
                        4,225Equipment
                        
                        
                        325
                        
                        
                        
                        367Occupancy
                        
                        
                        852
                        
                        
                        
                        772Other
                        
                        
                        2,445
                        
                        
                        
                        2,256Total
      non-interest expenses
                        
                        
                        7,425
                        
                        
                        
                        7,620Income
      before provision for income taxes
                        
                        
                        1,692
                        
                        
                        
                        2,699Provision
      for income taxes
                        
                        
                        590
                        
                        
                        
                        1,024Net
      income
                        
                        
                        1,102
                        
                        
                        
                        1,675Dividends
      and accretion on preferred stock
                        
                        
                        11
                        
                        
                        
                        -Net
      income available to common shareholders
                        
                        $
                        1,091
                        
                        
                        $
                        1,675Earnings
      Per Common ShareBasic
                        
                        $
                        0.14
                        
                        
                        $
                        0.22Diluted
                        
                        $
                        0.14
                        
                        
                        $
                        0.21





See notes
to condensed consolidated financial statements.





- 5
-





Heritage Oaks
Bancorp


and Subsidiaries


Consolidated Statements of
Stockholders' Equity





AccumulatedPreferred
      Stock
                                            
                                            
                                            Common
      Stock
                                            
                                            
                                            Additional
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            Other
                                            
                                            
                                            TotalNumber
      of
                                            
                                            
                                            
                                            
                                            
                                            Number
      of
                                            
                                            
                                            
                                            
                                            
                                            Paid-In
                                            
                                            
                                            Comprehensive
                                            
                                            
                                            Retained
                                            
                                            
                                            Comprehensive
                                            
                                            
                                            Stockholders'(dollars
      in thousands)
                                            
                                            Shares
                                            
                                            
                                            Amount
                                            
                                            
                                            Shares
                                            
                                            
                                            Amount
                                            
                                            
                                            Capital
                                            
                                            
                                            Income
                                            
                                            
                                            Earnings
                                            
                                            
                                            Income
                                            
                                            
                                            EquityBalance,
      December 31, 2008
                                            
                                            
                                            -
                                            
                                            
                                            $
                                            -
                                            
                                            
                                            
                                            7,753,078
                                            
                                            
                                            $
                                            48,649
                                            
                                            
                                            $
                                            1,055
                                            
                                            
                                            
                                            
                                            
                                            $
                                            21,420
                                            
                                            
                                            $
                                            (1,092
                                            )
                                            
                                            $
                                            70,032Issuance
      of preferred stock andcommon
      stock warrant
                                            
                                            
                                            21,000
                                            
                                            
                                            
                                            19,152
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            1,848
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            21,000Amortization
      of discount on
                                              preferred shares
                                            
                                            
                                            
                                            
                                            
                                            
                                            11
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            (11
                                            )
                                            
                                            
                                            
                                            
                                            
                                            
                                            -Share-based
      compensation expense
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            90
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            90Retirement
      of restricted share awards
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            (1,312
                                            )Comprehensive
      income:Net
      income
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            $
                                            1,102
                                            
                                            
                                            
                                            1,102
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            1,102Unrealized
      security holding gains (net of $463 tax benefit)
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            (663
                                            )
                                            
                                            
                                            
                                            
                                            
                                            
                                            (663
                                            )
                                            
                                            
                                            (663
                                            )Realized
      gains on sale of securities (net of $50 tax)
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            72
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            72
                                            
                                            
                                            
                                            72Total
      comprehensive income
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            $
                                            511Balance,
      March 31, 2009
                                            
                                            
                                            21,000
                                            
                                            
                                            $
                                            19,163
                                            
                                            
                                            
                                            7,751,766
                                            
                                            
                                            $
                                            48,649
                                            
                                            
                                            $
                                            2,993
                                            
                                            
                                            
                                            
                                            
                                            
                                            $
                                            22,511
                                            
                                            
                                            $
                                            (1,683
                                            )
                                            
                                            $
                                            91,633Balance,
      December 31, 2007
                                            
                                            
                                            -
                                            
                                            
                                            $
                                            -
                                            
                                            
                                            
                                            7,317,932
                                            
                                            
                                            $
                                            43,996
                                            
                                            
                                            $
                                            672
                                            
                                            
                                            
                                            
                                            
                                            
                                            $
                                            24,598
                                            
                                            
                                            $
                                            184
                                            
                                            
                                            $
                                            69,450Exercise
      of stock options  (including $58 excess tax benefit from
      exercise of stock options)
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            17,287
                                            
                                            
                                            
                                            138
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            1385%
      Stock Dividend distributed May 16, 2008
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            366,811
                                            
                                            
                                            
                                            4,677
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            (4,677
                                            )
                                            
                                            
                                            
                                            
                                            
                                            
                                            -Cash
      dividends - $0.08 per share
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            (587
                                            )
                                            
                                            
                                            
                                            
                                            
                                            
                                            (587
                                            )Share-based
      compensation expense
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            113
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            113Issuance
      of restricted stock awards
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            1,000
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            -Comprehensive
      income:Net
      income
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            $
                                            1,675
                                            
                                            
                                            
                                            1,675
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            1,675Unrealized
      security holding gains  (net of $125 tax)
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            179
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            179
                                            
                                            
                                            
                                            179Total
      comprehensive income
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            
                                            $
                                            1,854Balance,
      March 31, 2008
                                            
                                            
                                            -
                                            
                                            
                                            $
                                            -
                                            
                                            
                                            
                                            7,703,030
                                            
                                            
                                            $
                                            48,811
                                            
                                            
                                            $
                                            785
                                            
                                            
                                            
                                            
                                            
                                            
                                            $
                                            21,009
                                            
                                            
                                            $
                                            363
                                            
                                            
                                            $
                                            70,968




See notes
to condensed consolidated financial statements.





- 6
-





Heritage Oaks
Bancorp


and
Subsidiaries


Consolidated Statements of
Comprehensive Income





For
      the three monthsended
      March 31,(dollars
      in thousands)
                          
                          2009
                          
                          
                          2008Net
      income
                          
                          $
                          1,102
                          
                          
                          $
                          1,675Other
      comprehensive (loss) / income before taxesUnrealized
      (losses) / gains on securities available for sale
                          
                          
                          (1,126
                          )
                          
                          
                          304Realized
      gains on sale of available for sale securities
                          
                          
                          122
                          
                          
                          
                          -Total
      other comprehensive (loss) / income before taxes
                          
                          
                          (1,004
                          )
                          
                          
                          304Unrealized
      income tax benefit / (tax) related to items in comprehensive (loss) /
      income
                          
                          
                          463
                          
                          
                          
                          (125
                          )Income
      tax related to the sale of available for sale securities
                          
                          
                          (50
                          )
                          
                          
                          -Total
      other comprehensive (loss) / income, net of taxes
                          
                          
                          (591
                          )
                          
                          
                          179Total
      comprehensive income
                          
                          $
                          511
                          
                          
                          $
                          1,854





See notes
to condensed consolidated financial statements.





- 7
-





Heritage Oaks
Bancorp


and
Subsidiaries


Consolidated Statements of Cash
Flows





For
      the three month periodsended
      March 31,(dollars
      in thousands)
                                    
                                    2009
                                    
                                    
                                    2008Cash
      flows from operating activities:Net
      income
                                    
                                    $
                                    1,102
                                    
                                    
                                    $
                                    1,675Adjustments
      to reconcile net income to net cash provided by operating
      activities:Depreciation
      and amortization
                                    
                                    
                                    270
                                    
                                    
                                    
                                    271Provision
      for possible loan losses
                                    
                                    
                                    2,110
                                    
                                    
                                    
                                    240Amortization
      of premiums / discounts on investment securities, net
                                    
                                    
                                    (32
                                    )
                                    
                                    
                                    (25
                                    )Amortization
      of intangible assets
                                    
                                    
                                    263
                                    
                                    
                                    
                                    215Share-based
      compensation expense
                                    
                                    
                                    90
                                    
                                    
                                    
                                    113Federal
      Home Loan Bank dividends received
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (41
                                    )Gain
      on sale of available for sale securities
                                    
                                    
                                    (122
                                    )
                                    
                                    
                                    -Increase
      in loans held for sale
                                    
                                    
                                    (5,867
                                    )
                                    
                                    
                                    (1,857
                                    )Net
      increase in bank owned life insurance
                                    
                                    
                                    (105
                                    )
                                    
                                    
                                    (97
                                    )Decrease
      in deferred tax asset
                                    
                                    
                                    6
                                    
                                    
                                    
                                    6Loss
      on sale and write-downs on other real estate owned
                                    
                                    
                                    100
                                    
                                    
                                    
                                    -Increase
      in other assets
                                    
                                    
                                    (651
                                    )
                                    
                                    
                                    (278
                                    )Increase
      / (decrease) in other liabilities
                                    
                                    
                                    655
                                    
                                    
                                    
                                    (241
                                    )Excess
      tax benefit related to share-based compensation expense
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (58
                                    )NET
      CASH (USED) IN OPERATING ACTIVITIES
                                    
                                    
                                    (2,181
                                    )
                                    
                                    
                                    (77
                                    )Cash
      flows from investing activities:Purchase
      of securities, available for sale
                                    
                                    
                                    (20,539
                                    )
                                    
                                    
                                    (9,923
                                    )Sale
      of available for sale securities
                                    
                                    
                                    4,762
                                    
                                    
                                    
                                    -Maturities
      and calls of available for sale securities
                                    
                                    
                                    610
                                    
                                    
                                    
                                    1,003Proceeds
      from principal reductions and maturities of available for sale
      mortgage backed securities
                                    
                                    
                                    2,478
                                    
                                    
                                    
                                    1,976Purchase
      of Federal Home Loan Bank stock
                                    
                                    
                                    (705
                                    )
                                    
                                    
                                    (316
                                    )Increase
      in loans, net
                                    
                                    
                                    (13,736
                                    )
                                    
                                    
                                    (26,620
                                    )Allowance
      for loan and lease loss recoveries
                                    
                                    
                                    3
                                    
                                    
                                    
                                    -Purchase
      of property, premises and equipment, net
                                    
                                    
                                    (282
                                    )
                                    
                                    
                                    (159
                                    )Purchase
      of bank owned life insurance
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (400
                                    )Proceeds
      from disposal of FF&E
                                    
                                    
                                    1
                                    
                                    
                                    
                                    -Proceeds
      from sale of other real estate owned
                                    
                                    
                                    87
                                    
                                    
                                    
                                    -NET
      CASH (USED) IN INVESTING ACTIVITIES
                                    
                                    
                                    (27,321
                                    )
                                    
                                    
                                    (34,439
                                    )Cash
      flows from financing activities:Increase
      / (decrease) in deposits, net
                                    
                                    
                                    61,300
                                    
                                    
                                    
                                    (54,353
                                    )Proceeds
      from Federal Home Loan Bank borrowing
                                    
                                    
                                    35,000
                                    
                                    
                                    
                                    155,005Repayments
      of Federal Home Loan Bank borrowing
                                    
                                    
                                    (49,000
                                    )
                                    
                                    
                                    (86,500
                                    )(Decrease)
      / increase in repurchase agreements
                                    
                                    
                                    (2,796
                                    )
                                    
                                    
                                    281Excess
      tax benefit related to share-based compensation expense
                                    
                                    
                                    -
                                    
                                    
                                    
                                    58Proceeds
      from exercise of stock options
                                    
                                    
                                    -
                                    
                                    
                                    
                                    80Cash
      dividends paid
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (587
                                    )Proceeds
      from issuance of preferred stock and common stock warrants,
      net
                                    
                                    
                                    21,000
                                    
                                    
                                    
                                    -NET
      CASH PROVIDED BY FINANCING ACTIVITIES
                                    
                                    
                                    65,504
                                    
                                    
                                    
                                    13,984Net
      increase / (decrease) in cash and cash equivalents
                                    
                                    
                                    36,002
                                    
                                    
                                    
                                    (20,532
                                    )Cash and cash equivalents,
      beginning of period
                                    
                                    
                                    24,571
                                    
                                    
                                    
                                    46,419Cash
      and cash equivalents, end of period
                                    
                                    $
                                    60,573
                                    
                                    
                                    $
                                    25,887Supplemental
      Cash Flow Disclosures:Cash
      Flow informationInterest
      paid
                                    
                                    $
                                    2,483
                                    
                                    
                                    $
                                    3,922Non-Cash
      Flow InformationChange
      in other valuation allowance for investment securities
                                    
                                    $
                                    (1,004
                                    )
                                    
                                    $
                                    304Loans
      transferred to OREO or foreclosed collateral
                                    
                                    $
                                    1,748
                                    
                                    
                                    $
                                    -





See notes
to condensed consolidated financial statements.




- 8
-





Notes to
Consolidated Financial Statements





Note
1.  Consolidated Financial Statements





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





The
condensed consolidated financial statements include the accounts of the Company
and its wholly-owned financial subsidiary, Heritage Oaks Bank (“the
Bank”).  All significant inter-company balances and transactions have
been eliminated. Heritage Oaks Capital Trusts II and III are unconsolidated
subsidiaries formed solely for the purpose of issuing trust preferred
securities. Operating results for the three months ended March 31, 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 months ended March 31, 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.





Note
2.  Investment Securities





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





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





(dollars
      in thousands)
                                              
                                              
                                              
                                              
                                              Gross
                                              
                                              
                                              GrossAmortized
                                              
                                              
                                              Unrealized
                                              
                                              
                                              Unrealized
                                              
                                              
                                              FairAs
      of March 31, 2009
                                              
                                              Cost
                                              
                                              
                                              Gains
                                              
                                              
                                              Losses
                                              
                                              
                                              ValueObligations
      of U.S. government agencies and corporations
                                              
                                              $
                                              147
                                              
                                              
                                              $
                                              -
                                              
                                              
                                              $
                                              (1
                                              )
                                              
                                              $
                                              146Mortgage-backed
      securities
                                              
                                              
                                              48,125
                                              
                                              
                                              
                                              194
                                              
                                              
                                              
                                              (3,254
                                              )
                                              
                                              
                                              45,065Obligations
      of state and political subdivisions
                                              
                                              
                                              17,079
                                              
                                              
                                              
                                              427
                                              
                                              
                                              
                                              (225
                                              )
                                              
                                              
                                              17,281Other
      securities
                                              
                                              
                                              109
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              109Total
                                              
                                              $
                                              65,460
                                              
                                              
                                              $
                                              621
                                              
                                              
                                              $
                                              (3,480
                                              )
                                              
                                              $
                                              62,601As
      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





- 9
-





Notes to
Consolidated Financial Statements


During
the three months ended March 31, 2009, the Company sold five securities in the
aggregate amount of $4.8 million.  In connection with the sale, the
Company recognized a pre tax gain of approximately $122 thousand.  No
securities were sold during the three months ended March 31, 2008.





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, current cash
flows, credit enhancements, loan-to-values, credit scores, delinquency and
default rates.





As of
March 31, 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 March 31,
2009 compared to December 31, 2008:





March 31
                          
                          
                          December 31,(dollars
      in thousands)
                          
                          2009
                          
                          
                          2008Real
      Estate SecuredMulti-family residential
                          
                          $
                          17,569
                          
                          
                          $
                          16,206Residential 1 to 4 family
                          
                          
                          23,063
                          
                          
                          
                          23,910Home equity lines of credit
                          
                          
                          28,929
                          
                          
                          
                          26,409Commercial
                          
                          
                          294,825
                          
                          
                          
                          285,631Farmland
                          
                          
                          9,426
                          
                          
                          
                          10,723CommercialCommercial and industrial
                          
                          
                          167,149
                          
                          
                          
                          157,674Agriculture
                          
                          
                          13,989
                          
                          
                          
                          13,744Other
                          
                          
                          575
                          
                          
                          
                          620ConstructionSingle family residential
                          
                          
                          16,590
                          
                          
                          
                          11,414Single family residential - Spec.
                          
                          
                          12,850
                          
                          
                          
                          15,395Tract
                          
                          
                          3,190
                          
                          
                          
                          2,431Multi-family
                          
                          
                          5,727
                          
                          
                          
                          5,808Hospitality
                          
                          
                          8,292
                          
                          
                          
                          18,630Commercial
                          
                          
                          21,056
                          
                          
                          
                          21,484Land
                          
                          
                          60,031
                          
                          
                          
                          61,681Installment
      loans to individuals
                          
                          
                          8,038
                          
                          
                          
                          7,851All
      other loans (including overdrafts)
                          
                          
                          342
                          
                          
                          
                          536Total loans, gross
                          
                          
                          691,641
                          
                          
                          
                          680,147Deferred loan fees
                          
                          
                          1,555
                          
                          
                          
                          1,701Reserve for possible loan losses
                          
                          
                          10,429
                          
                          
                          
                          10,412Total loans, net
                          
                          $
                          679,657
                          
                          
                          $
                          668,034Loans
      held for sale
                          
                          $
                          13,806
                          
                          
                          
                          7,939





- 10
-


Notes to
Consolidated Financial Statements





Concentration
of Credit Risk





At March
31, 2009, approximately $501.5 million or 72.5% of the Bank’s loan portfolio was
collateralized by various forms of real estate, this represents an increase of
approximately $1.8 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 March 31,
2009, the Bank was contingently liable for letters of credit accommodations made
to its customers totaling approximately $18.1 million and un-disbursed loan
commitments in the approximate amount of $192.6 million. The Bank makes
commitments to extend credit in the normal course of business to meet the
financing needs of its customers. Commitments to extend credit are agreements to
lend to a customer as long as there is no violation of any condition established
in the contract. Commitments generally have fixed expiration dates or other
termination clauses and may require payment of a fee. Since many of the
commitments are expected to expire without being drawn upon, the total
outstanding commitment amount does not necessarily represent future cash
requirements. Standby letters of credit written are conditional commitments
issued by the Bank to guarantee the performance of a customer to a third party.
The credit risk involved in issuing letters of credit is essentially the same as
those involved in extending loan facilities to customers. The Bank anticipates
no losses as a result of such transactions. For more detailed information on
Concentration of Credit Risk, please refer to “Loans” of “Financial Condition”
under “Management’s Discussion and Analysis of Results and Operations” contained
within this document.





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 year ended(dollars in thousands)
                            
                            March 31, 2009
                            
                            
                            March 31, 2008
                            
                            
                            December 31, 2008Balance
      at beginning of period
                            
                            $
                            10,412
                            
                            
                            $
                            6,143
                            
                            
                            $
                            6,143Provision
      expense
                            
                            
                            2,110
                            
                            
                            
                            240
                            
                            
                            
                            12,215Loans
      charged-off:Commercial
      and industrial
                            
                            
                            283
                            
                            
                            
                            77
                            
                            
                            
                            3,854Construction
                            
                            
                            1,406
                            
                            
                            
                            -
                            
                            
                            
                            1,837Land
                            
                            
                            310
                            
                            
                            
                            -
                            
                            
                            
                            1,4341-4
      family residential
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            555Commercial
      real estate
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            340Other
                            
                            
                            97
                            
                            
                            
                            1
                            
                            
                            
                            56Total
      charge-offs
                            
                            
                            2,096
                            
                            
                            
                            78
                            
                            
                            
                            8,076Recoveries
      of loans previously charged off
                            
                            
                            3
                            
                            
                            
                            -
                            
                            
                            
                            130Balance
      at end of period
                            
                            $
                            10,429
                            
                            
                            $
                            6,305
                            
                            
                            $
                            10,412





During
the three months ended March 31, 2009, the Company made provisions to the
allowance for loan losses in the amount of $2.1 million.  This when
compared to the $0.2 million reported for the three months ended March 31, 2008,
represents an increase of approximately $1.9 million.  Year over year
increases in provision expenses are reflective of, among other things,
additional loan balances charged-off during the first quarter 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.





- 11
-




Notes to
Consolidated Financial Statements


Note
4.  Earnings Per Share





Basic
earnings per common share are computed by dividing net income available to
common shareholders by the weighted-average number of common shares
outstanding.  Diluted earnings per common share is computed by
dividing net income available to common shareholders by the weighted-average
number of common shares outstanding adjusted to include the effect of
potentially dilutive common shares.  Potentially dilutive common
shares are calculated using the Treasury Stock Method and include incremental
shares issuable upon exercise of outstanding stock options and other share-based
compensation awards, exclusive of any award that may have an anti-dilutive
affect on earnings per common share.  As disclosed in Note 8 of these
consolidated financial statements, the Company issued a warrant to the U.S.
Treasury to purchase 611,650 shares of our common stock.  The warrant
was excluded from the calculation of diluted earnings per common share during
the three months ended March 31, 2009, since they were
anti-dilutive.





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 March 31, 2009
and 2008:





For
      the three months ending,March
      31, 2008
                                                      
                                                      
                                                      March
      31, 2009Net
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      Net(dollar
      amounts in thousands except per share data)
                                                      
                                                      Income
                                                      
                                                      
                                                      Shares
                                                      
                                                      
                                                      Income
                                                      
                                                      
                                                      SharesNet
      income
                                                      
                                                      $
                                                      1,102
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      $
                                                      1,675Dividends
      and accretion on preferred stock
                                                      
                                                      
                                                      (11
                                                      )
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      -Net
      income available to common shareholders
                                                      
                                                      $
                                                      1,091
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      $
                                                      1,675Weighted
      average shares outstanding
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      7,689,317
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      7,694,546Basic
      earnings per common share
                                                      
                                                      $
                                                      0.14
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      $
                                                      0.22Dilutive
      effect of share-based compensation awards
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      135,060
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      157,285Weighted
      average diluted shares outstanding
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      7,824,377
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      7,851,831Diluted
      earnings per common share
                                                      
                                                      $
                                                      0.14
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      
                                                      $
                                                      0.21





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 table 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 April
2009, the Financial Accounting Standards Board (“FASB”) issued the following new
accounting standards:





In April
2009, the FASB issued FASB Staff Position (“FSP”) FAS 157-4, “Determining Whether a Market Is Not
Active and a Transaction Is Not Distressed,” FSP FAS 157-4 provides
guidelines for making fair value measurements more consistent with the
principles presented in SFAS 157. FSP FAS 157-4 provides additional
authoritative guidance in determining whether a market is active or inactive,
and whether a transaction is distressed, is applicable to all assets and
liabilities (i.e. financial and nonfinancial) and will require enhanced
disclosures.





In April
2009, the FASB issued FSP FAS 115-2, FAS 124-2, and EITF 99-20-2, “Recognition and Presentation of
Other-Than-Temporary Impairments,”  The FSP amends FASB
Statements No. 115, Accounting
for Certain Investments in Debt and Equity Securities, No. 124, Accounting for Certain Investments Held by
Not-for-Profit Organizations, and EITF Issue No. 99-20, “Recognition of Interest Income and
Impairment on Purchased Beneficial Interests and Beneficial Interests That
Continue to Be Held by a Transferor in Securitized Financial Assets,” to
make the other-than-temporary impairment guidance more operational and to
improve the presentation of other-than-temporary impairments in the financial
statements.  This statement applies to other-than-temporary
impairments of debt and equity securities and requires a company to assert that
(a) it does not have the intent to sell the security in question and (b) it is
more likely than not that it will not have to sell the security in question
before recovery of its cost basis to avoid an impairment being considered
other-than-temporary.  This FSP also changes the amount of impairment
losses recognized in earnings.  Under this FSP impairments are
separated into two components: (i) the amount of impairments related to credit
losses and (ii) and the amount related to other factors.  The amount
of impairment related to credit losses is reflected as a charge to earnings,
while the amount deemed to be related to other factors is reflected as an
adjustment to shareholders’ equity through other comprehensive
income.





In April
2009 the FASB issued FSP FAS 107-1 and APB 28-1, “Interim Disclosures about Fair
Value of Financial Instrument.” FSP FAS 107-1 and APB 28-1, amends FASB
Statement No. 107, “Disclosures about Fair Value of
Financial Instruments,” to require disclosures about fair value of
financial instruments in interim as well as in annual financial statements. This
FSP also amends APB Opinion No. 28, “Interim Financial
Reporting,” to require those disclosures in all interim financial
statements.





- 12
-


Notes to
Consolidated Financial Statements





The
standards summarized in the preceding paragraphs are effective for periods
ending after June 15, 2009.  The Company is currently determining the
impact these standards will have on our financial statements.





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





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





In
September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined
Benefit Pension and Other Postretirement Plans (an amendment of FASB Statements
No. 87, 88, 106, and 132R).” SFAS No. 158, requires an employer to:
(1) Recognize in its statement of financial position an asset for a plan’s
over funded status or a liability for a plan’s under funded status;
(2) measure a plan’s assets and its obligations that determine its funded
status as of the end of the employer’s fiscal year (with limited exceptions);
and (3) recognize changes in the funded status of a defined benefit
postretirement plan in the year in which the changes occur. Those changes will
be reported in comprehensive income of a business entity and in changes in net
assets of a not-for-profit organization. The requirement by SFAS No. 158 to
recognize the funded status of a benefit plan and the disclosure requirements of
SFAS No. 158 are effective as of the end of the fiscal year ending after
December 15, 2006 for entities with publicly traded equity securities. The
Company adopted this portion of the pronouncement effective January 1, 2007. The
adoption of this portion has not had a material impact on the financial
position, results of operation or cash flows of the Company. The requirement to
measure plan assets and benefit obligations as of the date of the employer’s
fiscal year-end statement of financial position is effective for fiscal years
ending after December 15, 2008. The adoption of SFAS No. 158 did not have a
material affect on the financial position of the company.





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





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





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





- 13
-


Notes to
Consolidated Financial Statements





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





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





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





On
October 10, 2008, the FASB issued FSP FAS 157-3, “Determining the Fair Value of a
Financial Asset When the Market for That Asset Is Not Active.” The FSP
clarifies the application of SFAS No. 157, “Fair Value Measurements”, in
a market that is not active and provides an example to illustrate key
considerations in determining the fair value of a financial asset when the
market for that financial asset is not active. The FSP is effective immediately,
and includes prior periods for which financial statements have not been issued,
and therefore the Company is subject to the provisions under the FSP effective
September 30, 2008. The implementation of FSP FAS 157-3 did not affect the
Company's fair value measurements as of March 31, 2009.





Note
6.  Share-Based Compensation





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





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





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





- 14
-




Notes to
Consolidated Financial Statements




The
share-based compensation expense recognized in the consolidated statements of
income for the three month periods ended March 31, 2009 and 2008 is based on
awards ultimately expected to vest, and accordingly has been adjusted by the
amount of estimated forfeitures. SFAS No. 123(R) requires forfeitures to be
estimated at the time of grant and revised, if necessary, in subsequent periods
if actual forfeitures differ from those estimates. Forfeitures were estimated
based partially on historical experience.





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





For
      the three months endedMarch
      31,(dollars
      in thousands except share and per share data)
                            
                            2009
                            
                            
                            2008Share-based
      compensation expense:Stock
      option expense
                            
                            $
                            44
                            
                            
                            $
                            50Restricted
      stock expense
                            
                            
                            46
                            
                            
                            
                            63Total
      share-based compensation expense
                            
                            
                            90
                            
                            
                            $
                            113Total
      share-based compensation expense, net of tax
                            
                            $
                            56
                            
                            
                            $
                            75Diluted
      shares outstanding
                            
                            
                            7,824,377
                            
                            
                            
                            7,851,831Impact
      on diluted earnings per share
                            
                            $
                            0.007
                            
                            
                            $
                            0.010Unrecognized
      compensation expense:Stock
      option expense
                            
                            $
                            279
                            
                            
                            $
                            418Restricted
      stock expense
                            
                            
                            425
                            
                            
                            
                            736Total
      unrecognized share-based compensation expense
                            
                            $
                            704
                            
                            
                            $
                            1,154Total
      unrecognized share-based compensation expense, net of tax
                            
                            $
                            420
                            
                            
                            $
                            712





At March
31, 2009, there was a total of $279 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 years.





The
Company grants restricted share awards periodically for the benefit of
employees. These restricted shares generally “cliff vest” after five years of
issuance. Recipients of restricted shares have the right to vote all shares
subject to such grant, and receive all dividends with respect to such shares,
whether or not the shares have vested. Recipients do not pay any cash
consideration for the shares.  The total unrecognized compensation
expense related to restricted share awards at March 31, 2009 was $425 thousand.
That expense is expected to be recognized over the next 2 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 first 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 March 31,
2009).  The aggregate pretax intrinsic value is subject to change
based on the fair market value of the Company's stock. The aggregate intrinsic
value of options exercised for the three month period ended March 31, 2008 was
$142 thousand.  There were no option exercises during the first
quarter of 2009.





- 15
-


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 March 31, 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
                                        
                                        
                                        25,000
                                        
                                        
                                        
                                        4.50Exercised
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -Forfeited
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -Options
      outstanding, March 31, 2009
                                        
                                        
                                        433,830
                                        
                                        
                                        $
                                        9.06
                                        
                                        
                                        
                                        4.43
                                        
                                        
                                        $
                                        31Exercisable
      at March 31, 2009
                                        
                                        
                                        354,033
                                        
                                        
                                        $
                                        8.74
                                        
                                        
                                        
                                        3.44
                                        
                                        
                                        $
                                        31Options
      outstanding, January 1, 2008
                                        
                                        
                                        463,149
                                        
                                        
                                        $
                                        8.33Granted
                                        
                                        
                                        26,250
                                        
                                        
                                        
                                        11.45Exercised
                                        
                                        
                                        (18,151
                                        )
                                        
                                        
                                        4.33Forfeited
                                        
                                        
                                        (3,572
                                        )
                                        
                                        
                                        5.66Options
      outstanding, March 31, 2008
                                        
                                        
                                        467,675
                                        
                                        
                                        $
                                        8.68
                                        
                                        
                                        
                                        4.56
                                        
                                        
                                        $
                                        1,749Exercisable
      at March 31, 2008
                                        
                                        
                                        372,882
                                        
                                        
                                        $
                                        7.60
                                        
                                        
                                        
                                        3.50
                                        
                                        
                                        $
                                        1,694





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





February
                        
                        
                        February2009
                        
                        
                        2008Expected
      volatility
                        
                        
                        41.61
                        %
                        
                        
                        35.07
                        %Expected
      term (years)
                        
                        
                        10
                        
                        
                        
                        10Dividend
      yield
                        
                        
                        0.00
                        %
                        
                        
                        2.66
                        %Risk
      free rate
                        
                        
                        2.76
                        %
                        
                        
                        3.62
                        %Weighted-average
      grant date fair value
                        
                        $
                        2.52
                        
                        
                        $
                        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 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.





- 16
-


Notes to
Consolidated Financial Statements


Note
7.  Fair Value of Financial Instruments





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





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





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





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





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





Fair
Value Measurements





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





Securities





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





Loans
Held For Sale





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





Impaired
Loans





A loan is
considered impaired when it is probable that payment of interest and principal
will not be made in accordance with the contractual terms of the loan
agreement.  Impairment is measured based on the fair value of the
underlying collateral or the discounted expected future cash
flows.  The Company measures impairment on all non-accrual 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 March 31, 2009, substantially all of the
Company’s impaired loans were evaluated based on the fair value of their
underlying collateral based upon the most recent appraisal available to
Management.







- 17
-


Notes to
Consolidated Financial Statements


Other
Real Estate Owned and Foreclosed Collateral





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





The
following table provides a summary of the financial instruments the Company
measures at fair value on a recurring basis as of March 31, 2009:





Fair
      Value Measurments UsingAssets At(dollars in thousands)
                        
                        Level 1
                        
                        
                        Level 2
                        
                        
                        Level 3
                        
                        
                        Fair ValueAssets:Available
      for sale investment securities
                        
                        $
                        -
                        
                        
                        $
                        61,914
                        
                        
                        $
                        687
                        
                        
                        $
                        62,601Total
      assets measured on a recurring basis
                        
                        $
                        -
                        
                        
                        $
                        61,914
                        
                        
                        $
                        687
                        
                        
                        $
                        62,601





The
following table provides a summary of the changes in balance sheet carrying
values associated with Level 3 financial instruments during the three months
ended March 31, 2009:





Available ForSale Investment(dollars in thousands)
                          
                          SecuritiesBeginning
      balance
                          
                          $
                          774Total
      gains or losses (realized/unrealized)(1):Included
      in earnings
                          
                          
                          -Included
      in other comprehensive income
                          
                          
                          (87
                          )Purchases
                          
                          
                          -Transfers
      in and/or out of Level 3
                          
                          
                          -Ending
      balance
                          
                          $
                          687





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





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





- 18
-


Notes to
Consolidated Financial Statements


The
following table provides a summary of the financial instruments the Company
measures at fair value on a non-recurring basis as of March 31,
2009:





Fair
      Value Measurments UsingAssets
      At(dollars
      in thousands)
                      
                      Level
      1
                      
                      
                      Level
      2
                      
                      
                      Level
      3
                      
                      
                      Fair
      ValueAssets:Impaired
      loans
                      
                      $
                      -
                      
                      
                      $
                      20,046
                      
                      
                      $
                      -
                      
                      
                      $
                      20,046Loans
      held for sale
                      
                      
                      -
                      
                      
                      
                      13,806
                      
                      
                      
                      -
                      
                      
                      
                      13,806Other
      real estate owned
                      
                      
                      -
                      
                      
                      
                      2,893
                      
                      
                      
                      -
                      
                      
                      
                      2,893Total
      assets measured on a non-recurring basis
                      
                      $
                      -
                      
                      
                      $
                      36,745
                      
                      
                      $
                      -
                      
                      
                      $
                      36,745





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





Note
8.  Preferred Stock





On
February 27, 2009, the Company received shareholder approval for an amendment of
our Articles of Incorporation to add a class of preferred stock, which has
ultimately allowed us 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.  The warrant
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 March 31, 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 relative fair value.  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.





- 19
-


Notes to
Consolidated Financial Statements


It is
also important to note that net income available to common shareholders will be
impacted to the extent the Company charges retained earnings for the accretion
of the discount on the Senior Preferred Stock and any dividends paid from
retained earnings on the Senior Preferred Stock.  For the three month
period ended March 31, 2009, charges to retained earnings in connection with the
accretion of the discount on the Senior Preferred Stock totaled approximately
$11 thousand.





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”).





Note
9.  Reclassifications





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





- 20
-





Forward
Looking Statements





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





- 21
-




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





The
following is an analysis of the results of operations and financial condition of
the Company as of and for the three month periods ending March 31, 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.





- 22
-


Management’s
Discussion and Analysis


Executive
Summary





For the
three month period ended March 31, 2009, the Company earned approximately $1.1
million or $0.14 per diluted share.  This, when compared to the $1.7
million or $0.21 per diluted share the Company earned in the same period ended a
year earlier, represents a decline in net income of approximately $0.6
million.  The primary reason behind the year over year decline in net
income can be attributed in large part to provisions the Bank made to the
allowance for loan losses during the first quarter of 2009.  For the
three month period ended March 31, 2009, provisions to the allowance for loan
losses were $2.1 million.  This represents and increase of
approximately $1.9 million when compared to the same period ended a year
earlier.  See also “Provision for Loan Losses” under “Results of
Operations” of this discussion and analysis for additional information regarding
provisions the Bank made to the allowance for loan losses during the first
quarter of 2009.





The
underlying business performance for the quarter was solid, with significant
demand deposit growth and moderate loan growth.  Total gross loans
grew 8.1% year-over-year and were up 1.7% from that reported at December 31,
2008.  Demand deposits were up 5.6% year-over-year, and up 11.7% from
that reported at December 31, 2008. Despite the increase in loan loss provision
the Company was still profitable in the first quarter and held its net interest
margin above 5%.





The Bank
continues diligent oversight of the loan portfolio and has been extremely
proactive in monitoring credit quality. Management has been and will continue to
perform internal credit reviews on a quarterly basis and has concluded that an
independent loan review will be conducted semi-annually in an effort to more
quickly identify any additional problem assets and mitigate any potential loss
to the Bank.





The
housing and general economic slowdown has led to an increase in non-performing
loans during the first quarter, which makes it prudent to write-down loans to
their current fair market value. The Bank is not waiting for regulators to tell
us when to write-down or charge off loans. The Bank has been diligent in
recognizing deficiencies inherent in impaired loans and proactively bringing the
balances in line with current values. The collateral securing the loans
charged-off during the first quarter consists of real estate and various forms
of business assets.  We are currently working with borrowers and
collateral is being actively marketed to minimize future
charge-offs.





The
Company’s liquidity has increased substantially as a result of strong deposit
growth during the quarter. The Company continues to benefit from new core
deposits from the inflow from the larger banks in our market
area.  The liquidity ratio was 11.50% at March 31, 2009, compared to
6.79% at December 31, 2008.  Additional sources of liquidity remain
strong, as the Bank has additional borrowing lines with the Federal Home Loan
Bank (“FHLB”) as well as credit arrangements with correspondent banks to provide
liquidity for a variety of reasons, including the day to day demands of
depositors.  At March 31, 2009, the Bank’s remaining capacity to
borrow against these lines was approximately $118.2
million.  Additionally, the Bank has established borrowing capacity at
the Federal Reserve Bank but has yet to provide collateral for the use of the
line. The Bank still has the ability to purchase brokered funds from a variety
of sources, providing for yet an additional source of secondary
funding.





The
following provides a summary of operating results for the periods ended March
31, 2009 and 2008:





·
            Interest
      income for the three month period ended March 31, 2009 was approximately
      $11.9 million.  This, when compared to the $12.8 million
      reported for the same period ended a year earlier, represents a decline of
      approximately $0.9 million  or 7.2%.  The year over
      year decline is primarily attributable to the actions taken by the Federal
      Reserve to lower the overnight Fed Funds rate from 4.25% to within a range
      of 0.00% and 0.25%.





·
            Interest
      expense for the three month period ended March 31, 2009 was approximately
      $2.3 million.  This, when compared to the $3.7 million reported
      for the same period ended a year earlier, represents a decline of
      approximately $1.4 million or 37.0%.  The year over year decline
      is mainly attributable to the dramatic declines in the overnight Fed Funds
      rate previously referred to above.





·
            Net
      interest income for the first quarter of 2009 was approximately $0.5
      million or 4.9% higher than the $9.1 million reported for the same period
      ended a year earlier.  An $83.5 million year over year increase
      in average interest earning assets contributed significantly to the year
      over year increase in net interest
income.





·
            The
      net interest margin for the first quarter of 2009 was 5.03% or 30 basis
      points lower than the 5.33% reported for the same period ended a year
      earlier.  Higher earning assets on a year over year basis in
      conjunction with a significant drop in interest rates placed pressure on
      the net interest margin.  However, since significant portions of
      the Bank’s interest bearing liabilities possess a floating rate, the Bank
      was able to mitigate substantial declines in the margin during a time
      where we saw the overnight Fed Funds rate decline by over 400 basis
      points.





- 23
-




Management’s
Discussion and Analysis


·
            Non-interest
      income for the three months ended March 31, 2009 was approximately $1.6
      million.  This, when compared to the $1.4 million reported for
      the same period ended a year earlier, represents an increase of
      approximately $0.2 million or 15.4%.  Increases in mortgage
      origination income as well as gains recognized on the sale of investment
      securities contributed to the year over year
  increase.





·
            Non-interest
      expenses for the three months ended March 31, 2009 were approximately $7.4
      million.  This, when compared to the $7.6 million reported for
      the same period ended a year earlier, represents a decline in the
      approximate amount of $0.2 million or 2.6%.  Efficiencies gained
      with respect to staffing as well as the implementation of additional
      expense controls have proved to be beneficial in reducing non-interest
      expenses on a year over year basis.





The
following provides a summary for significant year to date changes in balances as
of March 31, 2009:





·
            At
      March 31, 2009, net loan balances were approximately $679.7 million or
      $11.7 million and 1.7% 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
      March 31, 2009, total deposits were approximately $664.8 million or $61.3
      million and 10.2% higher than the $603.5 million reported at December 31,
      2008.  Deposits, exclusive of brokered were approximately $580.3
      million or $25.4 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
      March 31, 2009, borrowings with the FHLB were $95.0 million or
      approximately $14.0 million lower than the $109.0 million reported at
      December 31, 2008.  Higher deposit balances and Management’s
      intent to ensure an appropriate mix of secondary funding resulted in fewer
      borrowings with the FHLB.





The
following provides an overview of asset quality as of March 31,
2009:





·
            At
      March 31, 2009, the balance of non-accruing loans was approximately $20.3
      million or $2.0 million higher than the $18.3 million reported at December
      31, 2008.





·
            As
      of March 31, 2009, the allowance for loan losses represented 1.51% of
      total gross loans and 1.53% of total gross loans as of December 31,
      2008.





·
            As
      previously mentioned, during the three months ended March 31, 2008, the
      Bank made provisions to the allowance for loan losses in the approximate
      amount of $2.1 million and charged-off approximately $2.1 million in loan
      balances.





·
            For
      the three months ended March 31, 2009, net charge-off’s to average gross
      loans were 0.30%.  When compared to the 0.01% reported for the
      same period ended a year earlier, represents an increase of approximately
      29 basis points.





·
            During
      the first quarter of 2009, the Bank moved approximately $1.7 million
      related to one loan to OREO status.  As of March 31, 2009, the
      balance of OREO was $2.9 million.





In spite
of the year to date increase in non-performing assets, the Bank is encouraged to
see sale activity for $3 million in non-performing assets that is expected to
close during the second quarter of 2009. There also appears to be increased bona
fide interest in properties as reflected in the commitment to purchase letter
the Bank recently received for another $1 million property.





See also
“Non Performing Assets” under “Financial Condition” of this discussion analysis
for additional information related asset quality.





- 24
-


Management’s
Discussion and Analysis




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 our 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 8. Preferred Stock, to the consolidated
financial statements filed on this Form 10-Q.





On
February 27, 2009, the Board of Directors of the Federal Deposit Insurance
Corporation (“FDIC”) voted to amend the restoration plan for the Deposit
Insurance Fund (“DIF”).  To ensure the continued strength of the DIF,
the FDIC will impose a special assessment on all insured institutions of 20
basis points on June 30, 2009 to be collected on September 30,
2009.  Under the ruling, the FDIC may impose an additional assessment
of 10 basis points after June 30, 2009 if deemed by the FDIC to be
necessary.  Although the exact dollar amount of this assessment will
not be known until the assessment date, the Company anticipates this ruling will
have a material impact on its results of operations during the second quarter of
2009.




Dividends
and Stock Repurchases





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 made no repurchases of its common stock during the three months ended
March 31, 2009 or for all of 2008.





- 25
-


Management’s
Discussion and Analysis




Selected
Financial Data





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





For the quarters ended,(dollars in thousands except per share data)
                  
                  03/31/09
                  
                  
                  12/31/08
                  
                  
                  09/30/08
                  
                  
                  06/30/08
                  
                  
                  03/31/08
                  
                  
                  12/31/07
                  
                  
                  09/30/07
                  
                  
                  06/30/07Return
      on average assets
                  
                  
                  0.54
                  %
                  
                  
                  -0.63
                  %
                  
                  
                  0.27
                  %
                  
                  
                  0.35
                  %
                  
                  
                  0.91
                  %
                  
                  
                  1.11
                  %
                  
                  
                  1.12
                  %
                  
                  
                  1.25
                  %Return
      on average equity
                  
                  
                  6.04
                  %
                  
                  
                  -6.93
                  %
                  
                  
                  2.94
                  %
                  
                  
                  3.84
                  %
                  
                  
                  9.55
                  %
                  
                  
                  11.65
                  %
                  
                  
                  12.09
                  %
                  
                  
                  13.84
                  %Return
      on average common equity
                  
                  
                  6.19
                  %
                  
                  
                  -6.93
                  %
                  
                  
                  2.94
                  %
                  
                  
                  3.84
                  %
                  
                  
                  9.55
                  %
                  
                  
                  11.65
                  %
                  
                  
                  12.09
                  %
                  
                  
                  13.84
                  %Average
      equity to average assets
                  
                  
                  8.95
                  %
                  
                  
                  9.06
                  %
                  
                  
                  9.16
                  %
                  
                  
                  9.14
                  %
                  
                  
                  9.48
                  %
                  
                  
                  9.49
                  %
                  
                  
                  9.27
                  %
                  
                  
                  9.02
                  %Average
      common equity to average assets
                  
                  
                  8.64
                  %
                  
                  
                  9.06
                  %
                  
                  
                  9.16
                  %
                  
                  
                  9.14
                  %
                  
                  
                  9.48
                  %
                  
                  
                  9.49
                  %
                  
                  
                  9.27
                  %
                  
                  
                  9.02
                  %Net
      interest margin
                  
                  
                  5.03
                  %
                  
                  
                  5.04
                  %
                  
                  
                  5.18
                  %
                  
                  
                  5.28
                  %
                  
                  
                  5.33
                  %
                  
                  
                  5.33
                  %
                  
                  
                  5.44
                  %
                  
                  
                  5.56
                  %Efficiency
      ratio*
                  
                  
                  66.71
                  %
                  
                  
                  66.43
                  %
                  
                  
                  64.40
                  %
                  
                  
                  66.31
                  %
                  
                  
                  72.17
                  %
                  
                  
                  67.26
                  %
                  
                  
                  66.89
                  %
                  
                  
                  64.32
                  %Average
      loans to average deposits
                  
                  
                  112.39
                  %
                  
                  
                  109.95
                  %
                  
                  
                  111.54
                  %
                  
                  
                  109.26
                  %
                  
                  
                  103.64
                  %
                  
                  
                  96.40
                  %
                  
                  
                  95.79
                  %
                  
                  
                  103.52
                  %Net
      Income
                  
                  $
                  1,102
                  
                  
                  $
                  (1,254
                  )
                  
                  $
                  534
                  
                  
                  $
                  691
                  
                  
                  $
                  1,675
                  
                  
                  $
                  1,978
                  
                  
                  $
                  1,628
                  
                  
                  $
                  1,800Net
      income available to common shareholders
                  
                  $
                  1,091
                  
                  
                  $
                  (1,254
                  )
                  
                  $
                  534
                  
                  
                  $
                  691
                  
                  
                  $
                  1,675
                  
                  
                  $
                  1,978
                  
                  
                  $
                  1,628
                  
                  
                  $
                  1,800Earnings
      Per Common Share:Basic
                  
                  $
                  0.14
                  
                  
                  $
                  (0.16
                  )
                  
                  $
                  0.07
                  
                  
                  $
                  0.09
                  
                  
                  $
                  0.22
                  
                  
                  $
                  0.26
                  
                  
                  $
                  0.24
                  
                  
                  $
                  0.27Diluted
                  
                  $
                  0.14
                  
                  
                  $
                  (0.16
                  )
                  
                  $
                  0.07
                  
                  
                  $
                  0.09
                  
                  
                  $
                  0.21
                  
                  
                  $
                  0.25
                  
                  
                  $
                  0.23
                  
                  
                  $
                  0.26Outstanding
      Shares:Basic
                  
                  
                  7,689,317
                  
                  
                  
                  7,660,342
                  
                  
                  
                  7,709,600
                  
                  
                  
                  7,705,174
                  
                  
                  
                  7,694,546
                  
                  
                  
                  7,682,730
                  
                  
                  
                  6,796,286
                  
                  
                  
                  6,754,321Diluted
                  
                  
                  7,824,377
                  
                  
                  
                  7,721,460
                  
                  
                  
                  7,798,321
                  
                  
                  
                  7,830,390
                  
                  
                  
                  7,851,831
                  
                  
                  
                  7,887,206
                  
                  
                  
                  7,013,070
                  
                  
                  
                  7,027,090





* 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.





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 our 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.





2008
proved to be a challenging year not only on the national level, but within the
state of California and more specifically our primary market area.  As
the U.S. housing market continued to wane throughout 2008 and economic growth
began to significantly slow, the ability of borrowers to satisfy their
obligations to the financial sector began to languish.  These among
other factors placed severe stress on the U.S. financial system, leading to a
crisis of confidence, further downturn in economic growth and unprecedented
volatility in the U.S. equity and credit markets.  As mentioned, our
primary market area has historically enjoyed a more stable level of economic
activity; however we believe these more macro level concerns have started to
become more evident within our market area.  Recent indications show
the unemployment rate within California to be approximately
11.2%.  Within our primary market area, recent indications show the
unemployment rate within San Luis Obispo and Santa Barbara major metropolitan
areas to be approximately 8.1% and 8.3%, respectively.  Additionally,
housing prices have fallen significantly year over year within California,
showing an approximate 42% year over year decline as of December
2008.  Within the Company’s primary market, we have seen housing
prices fall in San Luis Obispo and Santa Barbara counties from year ago levels
by approximately 29% and 34%, respectively.  However, sales have been
relatively strong within the Company’s primary market area, climbing
approximately 32% during 2008, the majority of which can be attributed to sales
of foreclosed properties.  That said, the lack of oversupply in our
market, desirable climate, close proximity to beaches, lakes and the wine
industry, for both San Luis Obispo and Santa Barbara Counties have to some
degree provided support for the real-estate market in our area.





- 26
-


Management’s
Discussion and Analysis




Critical
Accounting Policies





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





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





Loans
and Interest on Loans





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





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





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





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





Allowance
for Loan Losses





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





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




- 27
-


Management’s
Discussion and Analysis


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





Other
Real Estate Owned





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





Securities
Available for Sale





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





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





Goodwill
and Other Intangible Assets





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





- 28
-


Management’s
Discussion and Analysis




Results
of Operations





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





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





For the
three months ended March 31, 2009 and 2008, the net interest margin was 5.03%
and 5.33%, respectively.





Historically,
the largest and most variable source of income for the Company is net interest
income. The results of operations for the three months ended March 31, 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 InterestIncome 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.





The
Company was able to keep the net interest margin in the 5% range during the
first quarter of 2009, down only 1bp compared to the previous quarter and 30bps
from the year ago quarter. The strong net interest margin is driven by floors
that have been placed on loans throughout the past several years and the ability
to re-price on the liability side of the balance sheet, specifically money
market Accounts and alternative sources of funding such as FHLB borrowing and
brokered deposits. The net interest margin was 5.03% for the first quarter of
2009, compared to 5.04% during the preceding quarter and 5.33% for the first
quarter a year ago.  This compares to a ratio of 4.02% for all
California Public Banks at December 31, 2008 (the most current data
published).





- 29
-


Management’s
Discussion and Analysis




The table
below sets forth average balance sheet information, interest income and expense,
average yields and rates and net interest income and margin for the three month
periods ended March 31, 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 endingMarch
      31, 2009
                                                                                                          
                                                                                                          
                                                                                                          March
      31, 2008Income/
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          Income/(dollars
      in thousands)
                                                                                                          
                                                                                                          Balance
                                                                                                          
                                                                                                          
                                                                                                          Rate
      (4)
                                                                                                          
                                                                                                          
                                                                                                          Expense
                                                                                                          
                                                                                                          
                                                                                                          Balance
                                                                                                          
                                                                                                          
                                                                                                          Rate
      (4)
                                                                                                          
                                                                                                          
                                                                                                          ExpenseInterest
      Earning Assets:Investments
      with other banks
                                                                                                          
                                                                                                          $
                                                                                                          119
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          3.41
                                                                                                          %
                                                                                                          
                                                                                                          $
                                                                                                          1
                                                                                                          
                                                                                                          
                                                                                                          $
                                                                                                          330
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          3.66
                                                                                                          %
                                                                                                          
                                                                                                          $
                                                                                                          3Investment
      securities taxable
                                                                                                          
                                                                                                          
                                                                                                          45,201
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          4.98
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          555
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          38,144
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          4.99
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          473Investment
      securities non-taxable
                                                                                                          
                                                                                                          
                                                                                                          17,163
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          4.40
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          186
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          17,122
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          4.30
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          183Federal
      funds sold
                                                                                                          
                                                                                                          
                                                                                                          12,844
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          0.22
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          7
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          8,013
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          3.36
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          67Loans
      (1) (2)
                                                                                                          
                                                                                                          
                                                                                                          695,774
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          6.50
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          11,147
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          623,981
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          7.79
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          12,091Total
      interest earning assets
                                                                                                          
                                                                                                          
                                                                                                          771,101
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          6.26
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          11,896
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          687,590
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          7.50
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          12,817Allowance
      for possible loan losses
                                                                                                          
                                                                                                          
                                                                                                          (10,623
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          (6,204
                                                                                                          )Other
      assets
                                                                                                          
                                                                                                          
                                                                                                          66,896
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          62,769Total
      assets
                                                                                                          
                                                                                                          $
                                                                                                          827,374
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          $
                                                                                                          744,155Interest
      Bearing Liabilities:Interest
      bearing demand
                                                                                                          
                                                                                                          $
                                                                                                          64,627
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          0.53
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          84
                                                                                                          
                                                                                                          
                                                                                                          $
                                                                                                          66,873
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          0.56
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          93Savings
                                                                                                          
                                                                                                          
                                                                                                          22,069
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          0.17
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          9
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          32,926
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          1.60
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          131Money
      market
                                                                                                          
                                                                                                          
                                                                                                          173,145
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          1.55
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          660
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          204,104
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          2.53
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          1,282Time
      deposits
                                                                                                          
                                                                                                          
                                                                                                          143,145
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          2.71
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          955
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          147,541
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          4.07
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          1,493Brokered
      money market funds
                                                                                                          
                                                                                                          
                                                                                                          40,860
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          0.64
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          64
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          -
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          0.00
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          -Brokered
      time deposits
                                                                                                          
                                                                                                          
                                                                                                          29,390
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          2.11
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          153
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          6,499
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          5.38
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          87Total
      interest bearing deposits
                                                                                                          
                                                                                                          
                                                                                                          473,236
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          1.65
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          1,925
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          457,943
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          2.71
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          3,086Federal
      funds purchased
                                                                                                          
                                                                                                          
                                                                                                          650
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          1.25
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          2
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          4,209
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          3.44
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          36Securities
      sold under agreement to repurchase
                                                                                                          
                                                                                                          
                                                                                                          2,638
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          0.15
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          1
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          2,065
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          3.12
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          16Federal
      Home Loan Bank borrowing
                                                                                                          
                                                                                                          
                                                                                                          109,478
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          0.91
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          246
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          43,610
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          3.10
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          336Junior
      subordinated debentures
                                                                                                          
                                                                                                          
                                                                                                          13,403
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          4.69
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          155
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          13,403
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          6.69
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          223Total
      borrowed funds
                                                                                                          
                                                                                                          
                                                                                                          126,169
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          1.30
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          404
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          63,287
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          3.88
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          611Total
      interest-bearing liabilities
                                                                                                          
                                                                                                          
                                                                                                          599,405
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          1.58
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          2,329
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          521,230
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          2.85
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          3,697Non-interest
      bearing demand
                                                                                                          
                                                                                                          
                                                                                                          145,849
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          144,108Total
      funding
                                                                                                          
                                                                                                          
                                                                                                          745,254
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          1.27
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          2,329
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          665,338
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          2.23
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          3,697Other
      liabilities
                                                                                                          
                                                                                                          
                                                                                                          8,086
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          8,247Total
      liabilities
                                                                                                          
                                                                                                          $
                                                                                                          753,340
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          $
                                                                                                          673,585Stockholders'
      Equity:Preferred
      stock
                                                                                                          
                                                                                                          $
                                                                                                          2,554
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          $
                                                                                                          -Common
      stock
                                                                                                          
                                                                                                          
                                                                                                          48,649
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          44,036Additional
      paid in capital
                                                                                                          
                                                                                                          
                                                                                                          1,338
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          711Retained
      earnings
                                                                                                          
                                                                                                          
                                                                                                          22,777
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          25,703Valuation
      allowance investments
                                                                                                          
                                                                                                          
                                                                                                          (1,284
                                                                                                          )
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          120Total
      stockholders' equity
                                                                                                          
                                                                                                          $
                                                                                                          74,034
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          $
                                                                                                          70,570Total
      liabilities and stockholders' equity
                                                                                                          
                                                                                                          $
                                                                                                          827,374
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          $
                                                                                                          744,155Net
      interest income
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          $
                                                                                                          9,567
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          $
                                                                                                          9,120Net
      interest margin (3)
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          5.03
                                                                                                          %
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          
                                                                                                          5.33
                                                                                                          %





(1)
              Nonaccrual
      loans have been included in total
loans.
 (2)
              Loan
      fees of $258 and $355 for the three months ending March 31, 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)
              Rate
      is annualized using actual number of days in
  period.




- 30
-




Management’s
Discussion and Analysis


The table
below sets forth changes in average interest earning assets and their respective
yields for the three month period ending March 31, 2009 compared to the same
period ended in 2008:




Average Balance
                        
                        
                        
                        
                        
                        
                        
                        
                        Average Yieldfor the three months ending
                        
                        
                        
                        
                        
                        
                        
                        
                        for the three months endingMarch 31,
                        
                        
                        Variance
                        
                        
                        March 31,(dollars in thousands)
                        
                        2009
                        
                        
                        2008
                        
                        
                        dollar
                        
                        
                        percentage
                        
                        
                        2009
                        
                        
                        2008
                        
                        
                        VarianceTime
      deposits with other banks
                        
                        $
                        119
                        
                        
                        $
                        330
                        
                        
                        $
                        (211
                        )
                        
                        
                        -63.94
                        %
                        
                        
                        3.41
                        %
                        
                        
                        3.66
                        %
                        
                        
                        -0.25
                        %Investment
      securities taxable
                        
                        
                        45,201
                        
                        
                        
                        38,144
                        
                        
                        
                        7,057
                        
                        
                        
                        18.50
                        %
                        
                        
                        4.98
                        %
                        
                        
                        4.99
                        %
                        
                        
                        -0.01
                        %Investment
      securities non-taxable
                        
                        
                        17,163
                        
                        
                        
                        17,122
                        
                        
                        
                        41
                        
                        
                        
                        0.24
                        %
                        
                        
                        4.40
                        %
                        
                        
                        4.30
                        %
                        
                        
                        0.10
                        %Federal
      funds sold
                        
                        
                        12,844
                        
                        
                        
                        8,013
                        
                        
                        
                        4,831
                        
                        
                        
                        60.29
                        %
                        
                        
                        0.22
                        %
                        
                        
                        3.36
                        %
                        
                        
                        -3.14
                        %Loans
      (1) (2)
                        
                        
                        695,774
                        
                        
                        
                        623,981
                        
                        
                        
                        71,793
                        
                        
                        
                        11.51
                        %
                        
                        
                        6.50
                        %
                        
                        
                        7.79
                        %
                        
                        
                        -1.29
                        %Total
      interest earning assets
                        
                        $
                        771,101
                        
                        
                        $
                        687,590
                        
                        
                        $
                        83,511
                        
                        
                        
                        12.15
                        %
                        
                        
                        6.26
                        %
                        
                        
                        7.50
                        %
                        
                        
                        -1.24
                        %


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


(2) Loan
fees of $258 and $355 for the three months ending March 31, 2009 and 2008,
respectively have been
included in the interest income computation.





At March
31, 2009, average interest earning assets were approximately $83.5 million
higher than that reported a year earlier. Organic growth in the loan portfolio
is the primary factor behind the increase.





For the
three month period ended March 31, 2009, the average yield on loans was
6.50%.  This represents a decline of 129 basis points from the 7.79%
reported for the same period ended a year earlier.  As economic
conditions worsened throughout 2008, the FOMC moved to cut the overnight Fed
Funds rate by over 400 basis points, which had a direct impact on yields in the
loan portfolio.  The decline in the yield of the loan portfolio is the
primary factor contributing to the year over year decline in the yield on
earning assets.  For the three month period ended March 31, 2009, the
yield on earning assets declined approximately 124 basis points when compared to
the same period ended a year ago.





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





The table
below sets forth changes in average interest bearing liabilities and their
respective rates for the three month period ending March 31, 2009 compared to
the same period ended in 2008:





Average Balance
                        
                        
                        
                        
                        
                        
                        
                        
                        Average Ratefor the three months ending
                        
                        
                        
                        
                        
                        
                        
                        
                        for the three months endingMarch 31,
                        
                        
                        Variance
                        
                        
                        March 31,(dollars in thousands)
                        
                        2009
                        
                        
                        2008
                        
                        
                        dollar
                        
                        
                        percentage
                        
                        
                        2009
                        
                        
                        2008
                        
                        
                        VarianceInterest bearing demand
                        
                        $
                        64,627
                        
                        
                        $
                        66,873
                        
                        
                        $
                        (2,246
                        )
                        
                        
                        -3.36
                        %
                        
                        
                        0.53
                        %
                        
                        
                        0.56
                        %
                        
                        
                        -0.03
                        %Savings
                        
                        
                        22,069
                        
                        
                        
                        32,926
                        
                        
                        
                        (10,857
                        )
                        
                        
                        -32.97
                        %
                        
                        
                        0.17
                        %
                        
                        
                        1.60
                        %
                        
                        
                        -1.43
                        %Money
      market
                        
                        
                        173,145
                        
                        
                        
                        204,104
                        
                        
                        
                        (30,959
                        )
                        
                        
                        -15.17
                        %
                        
                        
                        1.55
                        %
                        
                        
                        2.53
                        %
                        
                        
                        -0.98
                        %Time
      deposits
                        
                        
                        143,145
                        
                        
                        
                        147,541
                        
                        
                        
                        (4,396
                        )
                        
                        
                        -2.98
                        %
                        
                        
                        2.71
                        %
                        
                        
                        4.07
                        %
                        
                        
                        -1.36
                        %Brokered
      money market funds
                        
                        
                        40,860
                        
                        
                        
                        -
                        
                        
                        
                        40,860
                        
                        
                        
                        100.00
                        %
                        
                        
                        0.64
                        %
                        
                        
                        0.00
                        %
                        
                        
                        0.64
                        %Brokered
      time deposits
                        
                        
                        29,390
                        
                        
                        
                        6,499
                        
                        
                        
                        22,891
                        
                        
                        
                        352.22
                        %
                        
                        
                        2.11
                        %
                        
                        
                        5.38
                        %
                        
                        
                        -3.27
                        %Federal
      funds purchased
                        
                        
                        650
                        
                        
                        
                        4,209
                        
                        
                        
                        (3,559
                        )
                        
                        
                        -84.56
                        %
                        
                        
                        1.25
                        %
                        
                        
                        3.44
                        %
                        
                        
                        -2.19
                        %Securities
      sold under agreement to repurchase
                        
                        
                        2,638
                        
                        
                        
                        2,065
                        
                        
                        
                        573
                        
                        
                        
                        27.75
                        %
                        
                        
                        0.15
                        %
                        
                        
                        3.12
                        %
                        
                        
                        -2.97
                        %Federal
      Home Loan Bank borrowing
                        
                        
                        109,478
                        
                        
                        
                        43,610
                        
                        
                        
                        65,868
                        
                        
                        
                        151.04
                        %
                        
                        
                        0.91
                        %
                        
                        
                        3.10
                        %
                        
                        
                        -2.19
                        %Long
      term debt
                        
                        
                        13,403
                        
                        
                        
                        13,403
                        
                        
                        
                        -
                        
                        
                        
                        0.00
                        %
                        
                        
                        4.69
                        %
                        
                        
                        6.69
                        %
                        
                        
                        -2.00
                        %Total
      interest-bearing liabilities
                        
                        $
                        599,405
                        
                        
                        $
                        521,230
                        
                        
                        $
                        78,175
                        
                        
                        
                        15.00
                        %
                        
                        
                        1.58
                        %
                        
                        
                        2.85
                        %
                        
                        
                        -1.27
                        %





At March
31, 2009, the balance of interest bearing liabilities was approximately $78.2
million higher than that reported a year earlier.  During the majority
of 2008 and into the first quarter of 2009, the Bank experienced continued
strong loan demand.  Meeting this demand with appropriately priced
funding proved to be challenging during 2008, resulting in higher year over year
average balances from alternative funding sources.  This is evidenced
in the table above, with increases in Federal Home Loan Bank borrowings,
brokered time deposits and additional money market deposits obtained from the
Reserve.  As conditions in the financial services industry worsened
dramatically throughout 2008, many financial institutions in severe need of
liquidity engaged in irrational deposit pricing, making it difficult for the
Bank to attract and retain core deposits.  Management chose not to
engage in this type of pricing and instead pursued other inexpensive sources of
funding to meet the demands of borrowers and mitigate any substantial year over
year decline in the net interest margin.





Additionally,
the Bank stayed relatively short with respect to its interest bearing
liabilities during 2008 and into the first quarter of 2009.  This
proved to be beneficial with respect to the cost of our interest bearing
liabilities as the Federal Reserve moved aggressively to lower the overnight Fed
Funds rate by over 400 basis during 2008.




- 31
-


Management’s
Discussion and Analysis





The
volume and rate variances table below sets forth the dollar difference in
interest earned and paid for each major category of interest-earning assets and
interest-bearing liabilities for the three month period ended March 31, 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 endedMarch 31, 2009 over 2008(dollars in thousands)
                                        
                                        Volume
                                        
                                        
                                        Rate
                                        
                                        
                                        TotalInterest
      Income:Loans
      (1)
                                        
                                        $
                                        2,122
                                        
                                        
                                        $
                                        (3,066
                                        )
                                        
                                        $
                                        (944
                                        )Investment
      securities taxable
                                        
                                        
                                        83
                                        
                                        
                                        
                                        (1
                                        )
                                        
                                        
                                        82Investment
      securities non-taxable (2)
                                        
                                        
                                        -
                                        
                                        
                                        
                                        5
                                        
                                        
                                        
                                        5Taxable
      equivalent adjustment (2)
                                        
                                        
                                        -
                                        
                                        
                                        
                                        (2
                                        )
                                        
                                        
                                        (2
                                        )Investments
      with other banks
                                        
                                        
                                        (2
                                        )
                                        
                                        
                                        -
                                        
                                        
                                        
                                        (2
                                        )Federal
      funds sold
                                        
                                        
                                        109
                                        
                                        
                                        
                                        (169
                                        )
                                        
                                        
                                        (60
                                        )Net
      increase (decrease)
                                        
                                        
                                        2,312
                                        
                                        
                                        
                                        (3,233
                                        )
                                        
                                        
                                        (921
                                        )Interest
      Expense:Savings,
      now, money market
                                        
                                        
                                        (211
                                        )
                                        
                                        
                                        (542
                                        )
                                        
                                        
                                        (753
                                        )Time
      deposits
                                        
                                        
                                        (44
                                        )
                                        
                                        
                                        (494
                                        )
                                        
                                        
                                        (538
                                        )Brokered
      funds
                                        
                                        
                                        80
                                        
                                        
                                        
                                        50
                                        
                                        
                                        
                                        130Other
      borrowings
                                        
                                        
                                        (183
                                        )
                                        
                                        
                                        44
                                        
                                        
                                        
                                        (139
                                        )Long
      term borrowings
                                        
                                        
                                        -
                                        
                                        
                                        
                                        (68
                                        )
                                        
                                        
                                        (68
                                        )Net
      increase (decrease)
                                        
                                        
                                        (358
                                        )
                                        
                                        
                                        (1,010
                                        )
                                        
                                        
                                        (1,368
                                        )Total
      net increase (decrease)
                                        
                                        $
                                        2,670
                                        
                                        
                                        $
                                        (2,223
                                        )
                                        
                                        $
                                        447





(1) Loan
fees of $258 and $355 for the three months ending March 31, 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 month period ended
March 31, 2009 compared to the same period ended in 2008:





For the three months endedMarch 31,
                                
                                
                                Variance(dollars in thousands)
                                
                                2009
                                
                                
                                2008
                                
                                
                                dollar
                                
                                
                                percentageService
      charges on deposit accounts
                                
                                $
                                712
                                
                                
                                $
                                772
                                
                                
                                $
                                (60
                                )
                                
                                
                                -7.77
                                %ATM/Debit
      Card transaction/interchange fees
                                
                                
                                215
                                
                                
                                
                                209
                                
                                
                                
                                6
                                
                                
                                
                                2.87
                                %Bancard
                                
                                
                                37
                                
                                
                                
                                43
                                
                                
                                
                                (6
                                )
                                
                                
                                -13.95
                                %Mortgage
      origination fees
                                
                                
                                330
                                
                                
                                
                                166
                                
                                
                                
                                164
                                
                                
                                
                                98.80
                                %Earnings
      on bank owned life insurance
                                
                                
                                122
                                
                                
                                
                                112
                                
                                
                                
                                10
                                
                                
                                
                                8.93
                                %Other
      commissions and fees
                                
                                
                                148
                                
                                
                                
                                137
                                
                                
                                
                                11
                                
                                
                                
                                8.03
                                %Gain
      on sale of investment securities
                                
                                
                                122
                                
                                
                                
                                -
                                
                                
                                
                                122
                                
                                
                                
                                100.00
                                %Loss
      on sale of OREO
                                
                                
                                (27
                                )
                                
                                
                                -
                                
                                
                                
                                (27
                                )
                                
                                
                                100.00
                                %Gain
      on sale of FF&E
                                
                                
                                1
                                
                                
                                
                                -
                                
                                
                                
                                1
                                
                                
                                
                                100.00
                                %Total
      non-interest income
                                
                                $
                                1,660
                                
                                
                                $
                                1,439
                                
                                
                                $
                                221
                                
                                
                                
                                15.36
                                %





Non-interest
income for the three months ended March 31, 2009 increased approximately $221
thousand or 15.4% when compared to the same period ended in
2008.  Contributing substantially to the year over year increase was
an increase in mortgage origination fee income.  Income within this
category increased approximately $164 thousand or 98.8% when compared to the
same period ended a year earlier.  The Bank witnessed a significant
increase in the number of home loan re-financings during the first quarter 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 mass exits by competitors from mortgage origination, approximately 18
months ago the Bank recognized the opportunity to expand the mortgage
origination department. The Bank hired a well seasoned mortgage manager who has
been able to expand the Bank’s penetration into the origination market both in
San Luis Obispo and Santa Barbara counties. This strategy has full traction at
this point as is exhibited by the revenue generation of the
department.


- 32
-




Management’s
Discussion and Analysis







The table
below illustrates the change in the number and total dollar volume of mortgage
loans originated during the three months ended March 31, 2009 when compared to
the same period ended in 2008.





For the three months ended March 31,(dollars in thousands)
                        
                        2009
                        
                        
                        2008
                        
                        
                        VarianceDollar
      volume
                        
                        $
                        42,065
                        
                        
                        $
                        16,404
                        
                        
                        
                        156.4
                        %Number
      of loans
                        
                        
                        129
                        
                        
                        
                        45
                        
                        
                        
                        186.7
                        %





Service
charges on deposit accounts declined approximately $60 thousand during the first
quarter of 2009 when compared to the same period ended a year earlier which can
be attributed to an approximate $42 thousand decline in fees charged to
customers for insufficient funds.





All other
non-interest income during the first quarter of 2009 was approximately $117
thousand higher than that reported for the same period ended a year
earlier.  The year over year increase within this category can be
attributed in large part to gains recognized from the sale of five investment
securities and equipment in the approximate amounts of $122 thousand and $1
thousand, respectively.  These gains were slightly offset by losses
the Bank recognized in connection with the sale of an OREO property in the
approximate amounts of $27 thousand.





Non-Interest
Expenses





The table
below sets forth changes in non-interest expenses for the three month period
ended March 31, 2009 compared to the same period ended in 2008:





For the three months endedMarch 31,
                                                
                                                
                                                Variance(dollars in thousands)
                                                
                                                2009
                                                
                                                
                                                2008
                                                
                                                
                                                dollar
                                                
                                                
                                                percentageSalaries
      and employee benefits
                                                
                                                $
                                                3,803
                                                
                                                
                                                $
                                                4,225
                                                
                                                
                                                $
                                                (422
                                                )
                                                
                                                
                                                -9.99
                                                %Occupancy
                                                
                                                
                                                852
                                                
                                                
                                                
                                                772
                                                
                                                
                                                
                                                80
                                                
                                                
                                                
                                                10.36
                                                %Equipment
                                                
                                                
                                                325
                                                
                                                
                                                
                                                367
                                                
                                                
                                                
                                                (42
                                                )
                                                
                                                
                                                -11.44
                                                %Promotional
                                                
                                                
                                                101
                                                
                                                
                                                
                                                247
                                                
                                                
                                                
                                                (146
                                                )
                                                
                                                
                                                -59.11
                                                %Data
      processing
                                                
                                                
                                                670
                                                
                                                
                                                
                                                654
                                                
                                                
                                                
                                                16
                                                
                                                
                                                
                                                2.45
                                                %Stationery
      and supplies
                                                
                                                
                                                105
                                                
                                                
                                                
                                                119
                                                
                                                
                                                
                                                (14
                                                )
                                                
                                                
                                                -11.76
                                                %Regulatory
      fees
                                                
                                                
                                                143
                                                
                                                
                                                
                                                108
                                                
                                                
                                                
                                                35
                                                
                                                
                                                
                                                32.41
                                                %Audit
      and tax costs
                                                
                                                
                                                148
                                                
                                                
                                                
                                                114
                                                
                                                
                                                
                                                34
                                                
                                                
                                                
                                                29.82
                                                %Amortization
      of core deposit intangible
                                                
                                                
                                                263
                                                
                                                
                                                
                                                215
                                                
                                                
                                                
                                                48
                                                
                                                
                                                
                                                22.33
                                                %Director
      fees
                                                
                                                
                                                83
                                                
                                                
                                                
                                                78
                                                
                                                
                                                
                                                5
                                                
                                                
                                                
                                                6.41
                                                %Communications
                                                
                                                
                                                62
                                                
                                                
                                                
                                                73
                                                
                                                
                                                
                                                (11
                                                )
                                                
                                                
                                                -15.07
                                                %Other
                                                
                                                
                                                870
                                                
                                                
                                                
                                                648
                                                
                                                
                                                
                                                222
                                                
                                                
                                                
                                                34.26
                                                %Total
      non-interest expense
                                                
                                                $
                                                7,425
                                                
                                                
                                                $
                                                7,620
                                                
                                                
                                                $
                                                (195
                                                )
                                                
                                                
                                                -2.56
                                                %





Salary
and Employee Benefits





Salaries
and employee related expenses declined approximately $422 thousand for the three
month period ended March 31, 2009 when compared to the same period ended a year
earlier.  Efficiencies the Bank gained with respect to staffing during
the later part of 2008 and into the first quarter of 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.


- 33
-




Management’s
Discussion and Analysis





Promotion
Expenses





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





Regulatory
Fees





For the
three months ended March 31, 2009, regulatory fees were approximately $35
thousand higher than that reported for the same period ended a year
earlier.  Quarterly assessment fees imposed by the FDIC have increased
from year ago levels and are expected to increase substantially further
throughout 2009.  Increased assessment fees are the result of the
FDIC’s efforts to strengthen the Deposit Insurance Fund.





Core
Deposit Intangible (“CDI”) Amortization





Upon the
acquisition of Business First the Company booked CDI in the approximate amount
of $3.8 million.  The balance of this intangible will be amortized
over a six year period pursuant to a schedule provided in the initial valuation
process.  For the three months ended March 31, 2009 CDI amortization
was approximately $48 thousand higher than that reported for the same period
ended in 2008 of which substantially all can be attributed to the Business First
acquisition.





Other
Expenses





Expenses
within this category increased approximately $222 thousand during the three
months ended March 31, 2009 when compared to the same period ended a year
ago.  The majority of the increase within this category can be
attributed to expenses incurred related to the acquisition of and maintenance of
foreclosed collateral in the approximate amount of $67 thousand as well as the
write down of two OREO properties.  Expenses related to OREO write
downs during the first quarter of 2009 totaled approximately $73 thousand and
are based upon updated appraisal information.





Year over
year increases within this category can also be attributed to increased loan
department costs related to strong mortgage origination volume.  Loan
department costs increased approximately $46 thousand from year ago
levels.





Provision
for Income Taxes





For the
three month periods ended March 31, 2009 and 2008 the provision for income taxes
was 34.9% and 37.9% of pre tax income.  The primary reason behind the
year over year decline in the Company’s effective tax rate when compared to the
same period ended a year earlier is attributable to substantial increases in the
provision for loan losses and the permanent difference associated with interest
income the Company earned on municipal securities as well as income from
holdings of bank owned life insurance becoming a larger percentage of overall
taxable income.





Provision
for Loan Losses





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





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.  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.


- 34
-




Management’s
Discussion and Analysis








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





The
allowance for loan losses is based on estimates, and ultimate losses will vary
from current estimates.  These estimates are reviewed monthly by the
Bank’s Directors, Loan Committee and full Board of Directors, and as
adjustments, either positive or negative, become necessary, a corresponding
increase or decrease is made in the provision for loan losses.  The
methodology used to determine the adequacy of the allowance for loan losses for
the three months ended March 31, 2009 is consistent with prior
periods.





The
Bank’s provision for loan losses was $2.1 million and $0.2 million for the three
month period ended March 31, 2009 and 2008, respectively.





Provisions
made to the allowance for loan losses during the first quarter of 2009, were
approximately $1.9 million higher than that reported for the same period a year
earlier.  As economic conditions throughout 2008 worsened on national,
state and local levels, the Bank moved to increase the allowance as required by
monthly analyses the Bank conducts in determining its adequacy to cover
potential losses in the loan portfolio.  The Bank employs the use of a
“watch list” and loan grading system to assist in monitoring the quality of
certain credits in the loan portfolio.  As loans on the watch list and
any other loan within the portfolio experience deterioration, the Bank typically
moves to downgrade such loans, resulting in an increase in the required
allowance to cover any potential losses.  Management believes the
significant economic downturn witnessed during 2008 and that has continued into
2009 has had a considerable impact on the ability of certain borrowers to
satisfy their obligations to the Bank, resulting in watch list expansion, loan
downgrades and corresponding increases in loan loss
provisions.  Additionally, the Bank makes estimates as to the impact
that certain economic factors will have on various credits within the
portfolio.  Negative economic trends witnessed during 2008 have
continued thus far into 2009 and contributed substantially to increases in the
required allowance to cover potential losses in the loan portfolio, resulting in
significant year over year increases in loan loss provisions.





Year over
year increases in the balance of non-performing loans as well as charge-offs
also contributed to the additional provisions the Bank made to the allowance for
loan losses during the first quarter of 2009.  Losses in the
commercial and industrial and construction and land segments of the loan
portfolio during the first quarter of 2009 when compared to the same period a
year earlier, increased significantly.  Although the majority of
losses within these segments of the portfolio were the result of several large
write-downs, the Bank has witnessed an increase in the number and total dollar
volume of past due and non-accruing balances within the commercial and
industrial, construction and land segments.  Continued increases in
the number and dollar volume of non-performing loans may result in further
provisions to the allowance for loan losses.





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





As of
March 31, 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.


- 35
-




Management’s
Discussion and Analysis





Financial
Condition





At March
31, 2009, total assets were $872.3 million.  This when compared to the
$805.6 million reported at December 31, 2008, represents an increase of
approximately $66.7 million.  An approximate $37.4 million increase in
the balance of federal funds sold is the primary reason behind the year to date
increase in total assets.  During March 2009, the Company obtained
$21.0 million under the U.S. Treasury’s CPP, which is reflected in the balance
of federal funds sold as of March 31, 2009.  The Company is currently
in the process of determining the most appropriate way to deploy these
funds.





Contributing
to the year to date increase in total assets was an $11.8 million increase in
the balance of investments held for sale, resulting from purchases the Bank made
during the first quarter of 2009.  Also contributing to the year to
date increase in total assets was an $11.6 million increase in net loan
balances.





At March
31, 2009, total deposits were approximately $664.8 million or approximately
$61.3 million higher than the $603.5 million reported at December 31,
2008.  Increases in non-interest bearing demand, savings and retail
time deposits contributed to the year to date increase in
deposits.  Increases in brokered deposits also contributed to the year
to date increase in total deposit balances, as the Bank chose to use a mix of
alternative sources to help fund balance sheet growth and rely less on Federal
Home Loan Bank borrowing.





Loans





At March
31, 2009 total gross loan balances were $691.6 million.  This
represents an increase of approximately $11.5 million or 1.7% from the $680.1
million reported at December 31, 2008.  Higher real estate secured and
commercial loan balances contributed to the majority of the year to date
increase in the portfolio.





The
following table provides a summary of year to date variances in the loan
portfolio as of March 31, 2009:





March 31,
                                        
                                        
                                        December 31,
                                        
                                        
                                        Variance(dollars in thousands)
                                        
                                        2009
                                        
                                        
                                        2008
                                        
                                        
                                        dollar
                                        
                                        
                                        percentageReal
      Estate SecuredMulti-family
      residential
                                        
                                        $
                                        17,569
                                        
                                        
                                        $
                                        16,206
                                        
                                        
                                        $
                                        1,363
                                        
                                        
                                        
                                        8.41
                                        %Residential
      1 to 4 family
                                        
                                        
                                        23,063
                                        
                                        
                                        
                                        23,910
                                        
                                        
                                        
                                        (847
                                        )
                                        
                                        
                                        -3.54
                                        %Home
      equity line of credit
                                        
                                        
                                        28,929
                                        
                                        
                                        
                                        26,409
                                        
                                        
                                        
                                        2,520
                                        
                                        
                                        
                                        9.54
                                        %Commercial
                                        
                                        
                                        294,825
                                        
                                        
                                        
                                        285,631
                                        
                                        
                                        
                                        9,194
                                        
                                        
                                        
                                        3.22
                                        %Farmland
                                        
                                        
                                        9,426
                                        
                                        
                                        
                                        10,723
                                        
                                        
                                        
                                        (1,297
                                        )
                                        
                                        
                                        -12.10
                                        %CommercialCommercial
      and industrial
                                        
                                        
                                        167,149
                                        
                                        
                                        
                                        157,674
                                        
                                        
                                        
                                        9,475
                                        
                                        
                                        
                                        6.01
                                        %Agriculture
                                        
                                        
                                        13,989
                                        
                                        
                                        
                                        13,744
                                        
                                        
                                        
                                        245
                                        
                                        
                                        
                                        1.78
                                        %Other
                                        
                                        
                                        575
                                        
                                        
                                        
                                        620
                                        
                                        
                                        
                                        (45
                                        )
                                        
                                        
                                        -7.26
                                        %ConstructionSingle
      family residential
                                        
                                        
                                        16,590
                                        
                                        
                                        
                                        11,414
                                        
                                        
                                        
                                        5,176
                                        
                                        
                                        
                                        45.35
                                        %Single
      family residential - Spec.
                                        
                                        
                                        12,850
                                        
                                        
                                        
                                        15,395
                                        
                                        
                                        
                                        (2,545
                                        )
                                        
                                        
                                        -16.53
                                        %Tract
                                        
                                        
                                        3,190
                                        
                                        
                                        
                                        2,431
                                        
                                        
                                        
                                        759
                                        
                                        
                                        
                                        31.22
                                        %Multi-family
                                        
                                        
                                        5,727
                                        
                                        
                                        
                                        5,808
                                        
                                        
                                        
                                        (81
                                        )
                                        
                                        
                                        -1.39
                                        %Hospitality
                                        
                                        
                                        8,292
                                        
                                        
                                        
                                        18,630
                                        
                                        
                                        
                                        (10,338
                                        )
                                        
                                        
                                        -55.49
                                        %Commercial
                                        
                                        
                                        21,056
                                        
                                        
                                        
                                        21,484
                                        
                                        
                                        
                                        (428
                                        )
                                        
                                        
                                        -1.99
                                        %Land
                                        
                                        
                                        60,031
                                        
                                        
                                        
                                        61,681
                                        
                                        
                                        
                                        (1,650
                                        )
                                        
                                        
                                        -2.68
                                        %Installment
      loans to individuals
                                        
                                        
                                        8,038
                                        
                                        
                                        
                                        7,851
                                        
                                        
                                        
                                        187
                                        
                                        
                                        
                                        2.38
                                        %All
      other loans (including overdrafts)
                                        
                                        
                                        342
                                        
                                        
                                        
                                        536
                                        
                                        
                                        
                                        (194
                                        )
                                        
                                        
                                        -36.19
                                        %Total
      loans, gross
                                        
                                        
                                        691,641
                                        
                                        
                                        
                                        680,147
                                        
                                        
                                        
                                        11,494
                                        
                                        
                                        
                                        1.69
                                        %Deferred
      loan fees
                                        
                                        
                                        1,555
                                        
                                        
                                        
                                        1,701
                                        
                                        
                                        
                                        (146
                                        )
                                        
                                        
                                        -8.58
                                        %Reserve
      for possible loan losses
                                        
                                        
                                        10,429
                                        
                                        
                                        
                                        10,412
                                        
                                        
                                        
                                        17
                                        
                                        
                                        
                                        0.16
                                        %Total
      loans, net
                                        
                                        $
                                        679,657
                                        
                                        
                                        $
                                        668,034
                                        
                                        
                                        $
                                        11,623
                                        
                                        
                                        
                                        1.74
                                        %Loans
      held for sale
                                        
                                        $
                                        13,806
                                        
                                        
                                        $
                                        7,939
                                        
                                        
                                        $
                                        5,867
                                        
                                        
                                        
                                        73.90
                                        %  - 36
-




Management’s
Discussion and Analysis





Real
Estate Secured





The
following table provides a break-down of the real estate secured segment of the
Bank’s loan portfolio as of March 31, 2009:





March 31, 2009
                          
                          
                          
                          
                          
                          Percent of
                          
                          
                          
                          
                          
                          SingleUndisbursed
                          
                          
                          Total Bank
                          
                          
                          Percent
                          
                          
                          Bank's Risk
                          
                          
                          Number
                          
                          
                          Largest(dollars in thousands)
                          
                          Balance
                          
                          
                          Commitment
                          
                          
                          Exposure
                          
                          
                          Composition
                          
                          
                          Based Capital
                          
                          
                          of Loans
                          
                          
                          LoanRetail
                          
                          $
                          37,122
                          
                          
                          $
                          677
                          
                          
                          $
                          37,799
                          
                          
                          
                          9.4
                          %
                          
                          
                          42.6
                          %
                          
                          
                          61
                          
                          
                          $
                          3,320Professional
                          
                          
                          71,490
                          
                          
                          
                          910
                          
                          
                          
                          72,400
                          
                          
                          
                          18.1
                          %
                          
                          
                          81.5
                          %
                          
                          
                          103
                          
                          
                          
                          8,875Hospitality
                          
                          
                          65,957
                          
                          
                          
                          20
                          
                          
                          
                          65,977
                          
                          
                          
                          16.5
                          %
                          
                          
                          74.3
                          %
                          
                          
                          39
                          
                          
                          
                          10,891Multi-family
                          
                          
                          17,569
                          
                          
                          
                          165
                          
                          
                          
                          17,734
                          
                          
                          
                          4.4
                          %
                          
                          
                          20.0
                          %
                          
                          
                          18
                          
                          
                          
                          5,837Home
      equity lines of credit
                          
                          
                          28,929
                          
                          
                          
                          20,839
                          
                          
                          
                          49,768
                          
                          
                          
                          12.4
                          %
                          
                          
                          56.0
                          %
                          
                          
                          297
                          
                          
                          
                          1,250Residential
      1 to 4 family
                          
                          
                          23,063
                          
                          
                          
                          946
                          
                          
                          
                          24,009
                          
                          
                          
                          6.0
                          %
                          
                          
                          27.0
                          %
                          
                          
                          65
                          
                          
                          
                          3,000Farmland
                          
                          
                          9,426
                          
                          
                          
                          1,673
                          
                          
                          
                          11,099
                          
                          
                          
                          2.8
                          %
                          
                          
                          12.5
                          %
                          
                          
                          23
                          
                          
                          
                          1,937Healthcare
      / medical
                          
                          
                          16,923
                          
                          
                          
                          -
                          
                          
                          
                          16,923
                          
                          
                          
                          4.2
                          %
                          
                          
                          19.1
                          %
                          
                          
                          30
                          
                          
                          
                          2,202Restaurants
      / food establishments
                          
                          
                          7,248
                          
                          
                          
                          -
                          
                          
                          
                          7,248
                          
                          
                          
                          1.8
                          %
                          
                          
                          8.2
                          %
                          
                          
                          14
                          
                          
                          
                          2,541Commercial
                          
                          
                          78,873
                          
                          
                          
                          1,412
                          
                          
                          
                          80,285
                          
                          
                          
                          20.0
                          %
                          
                          
                          90.4
                          %
                          
                          
                          116
                          
                          
                          
                          4,714Other
                          
                          
                          17,212
                          
                          
                          
                          351
                          
                          
                          
                          17,563
                          
                          
                          
                          4.4
                          %
                          
                          
                          19.8
                          %
                          
                          
                          33
                          
                          
                          
                          2,865Total
      real estate secured
                          
                          $
                          373,812
                          
                          
                          $
                          26,993
                          
                          
                          $
                          400,805
                          
                          
                          
                          100.0
                          %
                          
                          
                          451.4
                          %
                          
                          
                          799
                          
                          
                          $
                          47,432




As of
March 31, 2009, real estate secured balances represented approximately $373.8
million of total gross loan balances.  This when compared to the
$362.9 million reported at December 31, 2008, represents an increase of
approximately $10.9 million or 3.0%.  The primary factor behind the
year to date increase within this category can be attributed to the completion
of two large construction projects and their subsequent reclassification from
construction to commercial real estate.  The aggregate balance of
these two loans totaled approximately $8.9 million as of March 31,
2009.  Also contributing to the increase in the commercial real estate
category was the funding of six new loans in amounts in excess of $100 thousand,
totaling approximately $4.1 million.  These loans were made to sectors
classified as hospitality, professional, healthcare / medical, and
commercial.  The Bank also had several pay downs in excess of $100
thousand in the aggregate amount of $3.1 million within this
category.





Loans
classified as multi-family residential also contributed to the year to date
increase within the real estate secured portfolio.  Contributing
substantially to the year to date increase was the funding of one loan in the
aggregate amount of $2.3 million.  This loan was made to a non profit
organization within the Bank’s primary market.  Notable pay downs
within this category include the pay down of one loan in the aggregate amount of
$1.3 million.





HELOC
disbursements also contributed to the year to date increase within the real
estate secured portfolio, rising approximately $2.5 million from the $26.4
million reported at December 31, 2008.





At March
31, 2009, real estate secured balances represented approximately 451.4% of the
Bank’s total risk based capital.  This when compared to the 510.7%
reported at December 31, 2008, represents a decline of 59.3 percentage
points.  The additional capital obtained under the U.S. Treasury’s CPP
is the primary factor behind the year to date decline.  Additionally,
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 March 31, 2009.





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





At March
31, 2009, approximately $161.1 million or 43.1% of the real estate secured
segment of the loan portfolio was considered owner occupied.


- 37
-




Management’s
Discussion and Analysis





Commercial





The
following table provides a break-down of the commercial and industrial segment
of the Bank’s commercial loan portfolio as of March 31, 2009:





March 31, 2009
                                                
                                                
                                                
                                                
                                                
                                                Percent of
                                                
                                                
                                                
                                                
                                                
                                                SingleUndisbursed
                                                
                                                
                                                Total Bank
                                                
                                                
                                                Percent
                                                
                                                
                                                Bank's Risk
                                                
                                                
                                                Number
                                                
                                                
                                                Largest(dollars in thousands)
                                                
                                                Balance
                                                
                                                
                                                Commitment
                                                
                                                
                                                Exposure
                                                
                                                
                                                Composition
                                                
                                                
                                                Based Capital
                                                
                                                
                                                of Loans
                                                
                                                
                                                LoanAgriculture
                                                
                                                $
                                                3,304
                                                
                                                
                                                $
                                                1,798
                                                
                                                
                                                $
                                                5,102
                                                
                                                
                                                
                                                2.0
                                                %
                                                
                                                
                                                5.7
                                                %
                                                
                                                
                                                26
                                                
                                                
                                                $
                                                2,000Oil
      / Gas and Utilities
                                                
                                                
                                                2,038
                                                
                                                
                                                
                                                916
                                                
                                                
                                                
                                                2,954
                                                
                                                
                                                
                                                1.2
                                                %
                                                
                                                
                                                3.3
                                                %
                                                
                                                
                                                12
                                                
                                                
                                                
                                                1,200Construction
                                                
                                                
                                                20,160
                                                
                                                
                                                
                                                15,745
                                                
                                                
                                                
                                                35,905
                                                
                                                
                                                
                                                14.1
                                                %
                                                
                                                
                                                40.4
                                                %
                                                
                                                
                                                174
                                                
                                                
                                                
                                                2,750Manufacturing
                                                
                                                
                                                12,311
                                                
                                                
                                                
                                                9,726
                                                
                                                
                                                
                                                22,037
                                                
                                                
                                                
                                                8.7
                                                %
                                                
                                                
                                                24.8
                                                %
                                                
                                                
                                                112
                                                
                                                
                                                
                                                2,100Wholesale
      and Retail
                                                
                                                
                                                14,197
                                                
                                                
                                                
                                                7,483
                                                
                                                
                                                
                                                21,680
                                                
                                                
                                                
                                                8.5
                                                %
                                                
                                                
                                                24.4
                                                %
                                                
                                                
                                                127
                                                
                                                
                                                
                                                1,250Transportation
      and Warehousing
                                                
                                                
                                                2,753
                                                
                                                
                                                
                                                598
                                                
                                                
                                                
                                                3,351
                                                
                                                
                                                
                                                1.3
                                                %
                                                
                                                
                                                3.8
                                                %
                                                
                                                
                                                35
                                                
                                                
                                                
                                                596Media
      & Information Services
                                                
                                                
                                                11,133
                                                
                                                
                                                
                                                2,507
                                                
                                                
                                                
                                                13,640
                                                
                                                
                                                
                                                5.4
                                                %
                                                
                                                
                                                15.4
                                                %
                                                
                                                
                                                26
                                                
                                                
                                                
                                                8,000Financial
      Services
                                                
                                                
                                                19,508
                                                
                                                
                                                
                                                7,151
                                                
                                                
                                                
                                                26,659
                                                
                                                
                                                
                                                10.5
                                                %
                                                
                                                
                                                30.0
                                                %
                                                
                                                
                                                51
                                                
                                                
                                                
                                                6,000Real-Estate
      / Rental  and Leasing
                                                
                                                
                                                16,110
                                                
                                                
                                                
                                                8,805
                                                
                                                
                                                
                                                24,915
                                                
                                                
                                                
                                                9.8
                                                %
                                                
                                                
                                                28.1
                                                %
                                                
                                                
                                                95
                                                
                                                
                                                
                                                3,500Professional
      Services
                                                
                                                
                                                19,449
                                                
                                                
                                                
                                                9,962
                                                
                                                
                                                
                                                29,411
                                                
                                                
                                                
                                                11.6
                                                %
                                                
                                                
                                                33.1
                                                %
                                                
                                                
                                                150
                                                
                                                
                                                
                                                2,000Healthcare
      / Medical & Social Services
                                                
                                                
                                                15,010
                                                
                                                
                                                
                                                18,387
                                                
                                                
                                                
                                                33,397
                                                
                                                
                                                
                                                13.1
                                                %
                                                
                                                
                                                37.6
                                                %
                                                
                                                
                                                118
                                                
                                                
                                                
                                                11,355Restaurants
      and Hospitality
                                                
                                                
                                                23,637
                                                
                                                
                                                
                                                3,302
                                                
                                                
                                                
                                                26,939
                                                
                                                
                                                
                                                10.6
                                                %
                                                
                                                
                                                30.3
                                                %
                                                
                                                
                                                109
                                                
                                                
                                                
                                                6,000All
      Other
                                                
                                                
                                                7,539
                                                
                                                
                                                
                                                890
                                                
                                                
                                                
                                                8,429
                                                
                                                
                                                
                                                3.2
                                                %
                                                
                                                
                                                9.5
                                                %
                                                
                                                
                                                66
                                                
                                                
                                                
                                                2,062Commercial
      and industrial
                                                
                                                $
                                                167,149
                                                
                                                
                                                $
                                                87,270
                                                
                                                
                                                $
                                                254,419
                                                
                                                
                                                
                                                100.0
                                                %
                                                
                                                
                                                286.4
                                                %
                                                
                                                
                                                1,101
                                                
                                                
                                                $
                                                48,813




At March
31, 2009, commercial loans represented approximately $181.7 million of total
gross loan balances.  This when compared to the $172.0 million
reported at December 31, 2008, represents an increase of approximately $9.7
million.  Increases in the commercial and industrial category were the
primary factor behind the year to date increase.





During
the first quarter of 2009, the Bank made notable disbursements on new and
existing loans in amounts of $250 thousand or more totaling approximately $11.3
million.  With the majority of these fundings attributable to new
loans within sectors classified as restaurants and hospitality, financial
services, oil / gas and utilities, manufacturing, construction, media and
information services, and professional.  Notable pay downs within the
commercial and industrial category in amounts of $250 thousand or more occurred
on ten such loans totaling approximately $6.7 million for the first quarter of
2009.





Although
the commercial and industrial category as a whole does represent a concentration
at 286.4% 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 March 31,
2009.





Construction





The
following table provides a break-down of the construction segment of the Bank’s
loan portfolio as of March 31, 2009:





March 31, 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
                          
                          $
                          16,590
                          
                          
                          $
                          7,784
                          
                          
                          $
                          24,374
                          
                          
                          
                          27.0
                          %
                          
                          
                          27.5
                          %
                          
                          
                          30
                          
                          
                          $
                          4,600Single
      family residential - Spec.
                          
                          
                          12,850
                          
                          
                          
                          908
                          
                          
                          
                          13,758
                          
                          
                          
                          15.3
                          %
                          
                          
                          15.5
                          %
                          
                          
                          14
                          
                          
                          
                          3,480Tract
                          
                          
                          3,190
                          
                          
                          
                          883
                          
                          
                          
                          4,073
                          
                          
                          
                          4.5
                          %
                          
                          
                          4.6
                          %
                          
                          
                          16
                          
                          
                          
                          649Multi-family
                          
                          
                          5,727
                          
                          
                          
                          2,256
                          
                          
                          
                          7,983
                          
                          
                          
                          8.9
                          %
                          
                          
                          9.0
                          %
                          
                          
                          5
                          
                          
                          
                          3,584Commercial
                          
                          
                          21,056
                          
                          
                          
                          4,562
                          
                          
                          
                          25,618
                          
                          
                          
                          28.4
                          %
                          
                          
                          28.9
                          %
                          
                          
                          23
                          
                          
                          
                          4,000Hospitality
                          
                          
                          8,292
                          
                          
                          
                          6,029
                          
                          
                          
                          14,321
                          
                          
                          
                          15.9
                          %
                          
                          
                          16.1
                          %
                          
                          
                          3
                          
                          
                          
                          7,359Total
      construction
                          
                          $
                          67,705
                          
                          
                          $
                          22,422
                          
                          
                          $
                          90,127
                          
                          
                          
                          100.0
                          %
                          
                          
                          101.6
                          %
                          
                          
                          91
                          
                          
                          $
                          23,672





At March
31, 2009, construction balances represented approximately $67.7 million or 9.8%
of total gross loan balances.  This when compared to the $75.2 million
reported at December 31, 2008, represents a decline of approximately $7.5
million. As previously alluded to 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.


- 38
-




Management’s
Discussion and Analysis








Increases
in the single family residential category can be attributed in large part to
disbursements on existing projects.  During the first quarter of 2009,
the Bank made two new loans within this category in the aggregate amount of $0.4
million.





Year to
date declines in the category of single family residential – spec can be
attributed in large part to the charge off of three loans to two borrowers in
the aggregate amount of $1.3 million as well as the movement of one loan in the
amount of $1.7 million to OREO status during the first quarter.





At March
31, 2009, hospitality construction loans were approximately $10.3 million lower
than the $18.6 million reported at December 31, 2008.  The year to
date decline can be attributed to one large loan in the approximate amount of
$7.9 million converting to an amortizing loan and moving to the commercial real
estate category.  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.





At March
31, 2009 approximately $5.3 million in construction loan balances were on non
accrual status.  See also “Non Performing Assets” of this Discussion
and Analysis filed for a more detailed discussion concerning the loans the Bank
has placed on non-accrual.





At March
31, 2009 total construction commitments represented approximately 101.6% 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 34.3
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
$26.4 million or 39.0% of the Bank’s construction portfolio was considered owner
occupied as of March 31, 2009.





Land





The
following table provides a break-down of the land segment of the Bank’s loan
portfolio as of March 31, 2009:





March 31, 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
                          
                          $
                          7,078
                          
                          
                          $
                          -
                          
                          
                          $
                          7,078
                          
                          
                          
                          11.2
                          %
                          
                          
                          8.0
                          %
                          
                          
                          24
                          
                          
                          $
                          1,000Single
      family residential - Spec.
                          
                          
                          2,102
                          
                          
                          
                          -
                          
                          
                          
                          2,102
                          
                          
                          
                          3.3
                          %
                          
                          
                          2.4
                          %
                          
                          
                          8
                          
                          
                          
                          618Tract
                          
                          
                          31,815
                          
                          
                          
                          2,206
                          
                          
                          
                          34,021
                          
                          
                          
                          53.6
                          %
                          
                          
                          38.3
                          %
                          
                          
                          12
                          
                          
                          
                          12,208Multi-family
                          
                          
                          2,755
                          
                          
                          
                          27
                          
                          
                          
                          2,782
                          
                          
                          
                          4.4
                          %
                          
                          
                          3.1
                          %
                          
                          
                          4
                          
                          
                          
                          2,604Commercial
                          
                          
                          12,200
                          
                          
                          
                          1,195
                          
                          
                          
                          13,395
                          
                          
                          
                          21.1
                          %
                          
                          
                          15.1
                          %
                          
                          
                          24
                          
                          
                          
                          1,500Hospitality
                          
                          
                          4,081
                          
                          
                          
                          -
                          
                          
                          
                          4,081
                          
                          
                          
                          6.4
                          %
                          
                          
                          4.6
                          %
                          
                          
                          4
                          
                          
                          
                          2,340Total
      land
                          
                          $
                          60,031
                          
                          
                          $
                          3,428
                          
                          
                          $
                          63,459
                          
                          
                          
                          100.0
                          %
                          
                          
                          71.5
                          %
                          
                          
                          76
                          
                          
                          $
                          20,270




At March
31, 2009, land balances represented approximately $60.0 million or 8.7% of total
gross loan balances.  When compared to the $61.7 million reported at
December 31, 2008, land balances declined approximately $1.7
million.  The year to date decline can be attributed in part to two
large loans in the aggregate amount of $1.6 million moving to the construction
category from land.  Significant pay downs and payoffs totaling
approximately $1.7 million also contributed to the year to date decline and can
be attributed to proceeds received from two borrowers.  During the
first quarter the Bank charged off approximately $0.3 million related to one
loan in the land segment, contributing further to the year to date decline
within this segment of the loan portfolio.





New loans
within this category include five loans to five borrowers in the aggregate
amount of $1.2 million.  These loans were classified as land –
commercial as of March 31, 2009 and were made to borrowers within the Bank’s
primary market area.





Two of
the largest loans within this category consist of loans for residential tract
developments in the aggregate amount of $12.5 million.  These projects
are located in Kern County of the California Central Valley.  One
project is approved for 314 single family lots.  This project has also
been approved for approximately 8.6 acres of commercial development and 13.5
acres for recreational purposes.  The project was funded in the first
quarter of 2008 and has an approximate loan to value of 50.0%, based on an
appraisal conducted at the time.  At March 31, 2009 the balance of
this loan was approximately $11.1 million, with approximately $1.1 million
un-disbursed.  However, given the current economic environment, the
borrower intends to delay commercial and residential development of the property
and instead has begun to develop the project site into a rock quarry operation,
with limited competition for this business in the borrower’s
market.   The borrower has begun to receive cash flows from these
operations and it is anticipated that it will provide significant cash flows in
future periods to help pay down the loan.  To that end, the Bank
intends to order a new appraisal of the property, including the quarry, and
require the borrower to maintain a maximum LTV of 50.0% based on new
appraisals.  Additionally, the Bank anticipates this loan to be
re-classed from Land Tract Development to Commercial and
Industrial.


- 39
-




Management’s
Discussion and Analysis








The
purpose of the second project is to provide affordable housing to a market
that generally consists of renters and is the only new housing development in
its area.  This loan funded in March 2008 at approximately $4.1
million and has subsequently been paid down by approximately $2.8 million from
proceeds of sold homes, with approximately $0.8 million in pay downs occurring
in the first quarter of 2009.  The borrower is actively marketing the
remaining finished homes and sales continue to occur at a rate of one to two
homes per month.  Additionally, the housing in this project qualifies
for the USDA Direct Loan program whereby individuals or families receive
financial assistance directly from the Housing and Community Facilities Programs
(“HCFP”) in the form of a home loan at an affordable interest
rate.  As of March 31, 2009, these loans were performing under the
contractual terms of their respective loan agreements.





Kern
County, somewhat outside of the Company’s market footprint, has a population of
approximately 817,000 and depends on agriculture, oil, light industry,
warehousing and distribution, and educational services to support its
economy.  This region of California’s Central Valley has experienced
significant population growth in recent years relative to other areas of the
state, with annual percentage increases of 2.5% or more per year over the last
five years.  Affordable housing, relative to other metropolitan areas
within California, has been a significant factor behind the growth in Kern
County’s population.  However, like many other areas within
California, real estate prices within the California Central Valley have fallen
significantly, with recent indications showing year over year declines in excess
of 30% and an approximate six month supply of unsold homes within Kern County,
specifically.  Management acknowledges that as economic conditions
worsen across the state, the level of growth previously experienced within the
California Central Valley as well the purchasing power of consumers within that
market will no doubt be negatively impacted.  As such, Management
continues to carefully monitor loans made to borrowers in the Central Valley for
any sign of deterioration.





The Bank
does not typically make loans outside of its market footprint unless the
potential for a long term relationship, including the acquisition of additional
core deposits, exists.  As mentioned, the Bank continues to closely
monitor both relationships it has established with borrowers in the Central
Valley for any signs of deterioration, given that they are out of our market
area.





At March
31, 2009 total land commitments represented 71.5% 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 13.7 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 March
31, 2009 approximately $8.9 million or 14.9% of total land balances were
considered owner occupied.





Installment





At March
31, 2009, the installment loan balances were approximately $8.0
million.  This, when compared to the $7.9 million reported at December
31, 2008, represents a increase of approximately $0.1
million.  Installment loans include revolving credit plans, consumer
loans, as well as credit card balances obtained in the acquisition of Business
First.





Loans
Held for Sale





Loans
held for sale consist of mortgage originations that have already been sold
pursuant to correspondent mortgage loan agreements. There is no interest rate
risk associated with these loans as the commitments are in place at the time the
Bank funds them. Settlement from the correspondents is typically within 30 to 45
days.  At March 31, 2009 mortgage correspondent loans (loans held for
sale) totaled approximately $13.8 million.  This when compared to the
$7.9 million reported at December 31, 2008, represents an increase of
approximately $5.9 million.  The dramatic year over year decline in
interest rates has lead to significantly higher mortgage re-financing volumes,
contributing substantially to the year to date increase within this
category.


- 40
-


Management’s
Discussion and Analysis







Foreign
Loans





At March
31, 2009 the Bank had no foreign loans outstanding.





Summary
of Market Condition





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





Sales of
single family homes have fallen significantly year over year in the Company’s
market area and California as a whole, with recent indications showing price
declines of approximately 42% statewide and 29% to 34% within the Company’s
market area.  Along with other segments in the real estate sector,
commercial real estate prices in the Company’s market area experienced some
pressure during 2008 and the Company has begun to see a slight increase in
vacancy rates in certain retail and office segments, though not to any
considerable extent.  However, the Company realizes that any prolonged
and significant downturn in the national and local economies will have an impact
on the values of commercial real estate within its market footprint as well as
the borrowers to whom the Bank has extended such credit and thus continues to
closely monitor the credits within this segment of the loan portfolio for
potential signs of deterioration.  Additionally, the Bank is aware
that as economic conditions worsen and levels of unemployment continue to rise,
borrowers to whom the Bank has extended commercial lines of credit may come
under additional pressure to satisfy their outstanding
obligations.  That said, the Bank continues to employ stringent
lending standards and remains very selective with regard to any additional
commercial real estate, real estate construction, land and commercial loans it
chooses to originate in an effort to effectively manage risk in this difficult
credit environment.





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





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.





As of
March 31, 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.




- 41
-




Management’s
Discussion and Analysis





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.





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





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




March
      31,
                          
                          
                          December
      31,(dollars
      in thousands)
                          
                          2009
                          
                          
                          2008Loans
      delinquent 90 days or more and still accruing
                          
                          $
                          -
                          
                          
                          $
                          348Non-Accruing
      Loans:Commercial
      real estate
                          
                          $
                          3,076
                          
                          
                          $
                          1,961Residential
      1-4 family
                          
                          
                          392
                          
                          
                          
                          265Home
      equity lines of credit
                          
                          
                          320
                          
                          
                          
                          320Commercial
                          
                          
                          7,309
                          
                          
                          
                          7,060Construction
                          
                          
                          5,282
                          
                          
                          
                          5,990Land
                          
                          
                          3,825
                          
                          
                          
                          2,720Installment
      loans
                          
                          
                          87
                          
                          
                          
                          11Total
      non-accruing loans
                          
                          $
                          20,291
                          
                          
                          $
                          18,327Other
      real estate owned
                          
                          $
                          2,893
                          
                          
                          $
                          1,337Total
      non-performing assets
                          
                          $
                          23,184
                          
                          
                          $
                          20,012Ratio
      of allowance for credit losses to total gross loans
                          
                          
                          1.51
                          %
                          
                          
                          1.53
                          %Ratio
      of allowance for credit losses to total non-performing
    loans
                          
                          
                          51.40
                          %
                          
                          
                          55.75
                          %Ratio
      of non-performing loans to total gross loans
                          
                          
                          2.93
                          %
                          
                          
                          2.75
                          %Ratio
      of non-performing assets to total assets
                          
                          
                          2.66
                          %
                          
                          
                          2.48
                          %




- 42
-




Management’s
Discussion and Analysis


At March
31, 2009 the balance of non-accruing loans was approximately $20.3 million or
$2.0 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 construction, land and commercial real
estate.





The
following table reconciles the change in non accruing balances for the three
months ended March 31, 2009:





Balance
                                                  
                                                  
                                                  Additions
      to
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  Transfers
      to OREO
                                                  
                                                  
                                                  BalanceDecember
      31,
                                                  
                                                  
                                                  Non-Accruing
                                                  
                                                  
                                                  Net
                                                  
                                                  
                                                  
                                                  
                                                  
                                                  or
      Foreclosed
                                                  
                                                  
                                                  March
      31,(dollars
      in thousands)
                                                  
                                                  2008
                                                  
                                                  
                                                  Balances
                                                  
                                                  
                                                  Paydowns
                                                  
                                                  
                                                  Charge-offs
                                                  
                                                  
                                                  Collateral
                                                  
                                                  
                                                  2009Real
      Estate SecuredMulti-family
      residential
                                                  
                                                  $
                                                  -
                                                  
                                                  
                                                  $
                                                  -
                                                  
                                                  
                                                  $
                                                  -
                                                  
                                                  
                                                  $
                                                  -
                                                  
                                                  
                                                  $
                                                  -
                                                  
                                                  
                                                  $
                                                  -Residential
      1 to 4 family
                                                  
                                                  
                                                  265
                                                  
                                                  
                                                  
                                                  146
                                                  
                                                  
                                                  
                                                  (19
                                                  )
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  392Home
      equity line of credit
                                                  
                                                  
                                                  320
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  320Commercial
                                                  
                                                  
                                                  1,961
                                                  
                                                  
                                                  
                                                  1,138
                                                  
                                                  
                                                  
                                                  (23
                                                  )
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  3,076Farmland
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -CommercialCommercial
      and industrial
                                                  
                                                  
                                                  7,060
                                                  
                                                  
                                                  
                                                  589
                                                  
                                                  
                                                  
                                                  (57
                                                  )
                                                  
                                                  
                                                  (283
                                                  )
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  7,309Agriculture
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -Other
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -ConstructionSingle
      family residential
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  823
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  (145
                                                  )
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  678Single
      family residential - Spec.
                                                  
                                                  
                                                  5,990
                                                  
                                                  
                                                  
                                                  1,589
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  (1,261
                                                  )
                                                  
                                                  
                                                  (1,714
                                                  )
                                                  
                                                  
                                                  4,604Tract
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -Multi-family
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -Hospitality
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -Commercial
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -Land
                                                  
                                                  
                                                  2,720
                                                  
                                                  
                                                  
                                                  1,421
                                                  
                                                  
                                                  
                                                  (6
                                                  )
                                                  
                                                  
                                                  (310
                                                  )
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  3,825Installment
      loans to individuals
                                                  
                                                  
                                                  11
                                                  
                                                  
                                                  
                                                  77
                                                  
                                                  
                                                  
                                                  (1
                                                  )
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  87All
      other loans
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  97
                                                  
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  (97
                                                  )
                                                  
                                                  
                                                  -
                                                  
                                                  
                                                  
                                                  -Totals
                                                  
                                                  $
                                                  18,327
                                                  
                                                  
                                                  $
                                                  5,880
                                                  
                                                  
                                                  $
                                                  (106
                                                  )
                                                  
                                                  $
                                                  (2,096
                                                  )
                                                  
                                                  $
                                                  (1,714
                                                  )
                                                  
                                                  $
                                                  20,291





The
following table reconciles the change in balances classified as 90 days past due
and still accruing for the three months ended March 31, 2009:





Balance
                
                
                Additions
      to
                
                
                Transfers
                
                
                
                
                
                Transfers
      to OREO
                
                
                BalanceDecember
      31,
                
                
                90
      Day Plus
                
                
                to
      Non-Accruing
                
                
                
                
                
                or
      Foreclosed
                
                
                March
      31,(dollars
      in thousands)
                
                2008
                
                
                Balances
                
                
                Status
                
                
                Charge-offs
                
                
                Collateral
                
                
                2009Loans
      90 days deliquent or more and still accruing
                
                $
                348
                
                
                $
                442
                
                
                $
                (790
                )
                
                $
                -
                
                
                $
                -
                
                
                $
                -





The
following provides additional information regarding non-accruing balances as of
March 31, 2009:





Real
Estate Secured Commercial





The $1.1
million addition consists of two loans, the larger of which, for approximately
$929 thousand is currently in the final stages of sale and is anticipated to
close before the end of the second quarter of 2009. This loan carries an
approximate LTV of 71%. The smaller loan is well secured with a LTV of
approximately 17% and also has interest from a buyer. There was no write-down
associated with either credit.





Two
existing loans to one borrower with a combined balance of $911 thousand are in
process of foreclosure and have been generating third party buyer interest. In
regard to another existing loan for $483 thousand, the Bank is in process of
foreclosure and there is considerable interest in the property because of the
low LTV of approximately 60%.





Commercial
and Industrial





The most
notable addition to this category is a loan for $300 thousand whereby the
borrower has considerable assets and the Bank is in the process of working with
the borrower. One loan in the amount of $224 thousand was added and subsequently
charged off during the quarter.


- 43
-




Management’s
Discussion and Analysis


Construction
Single Family Residential





The new
items consist of two loans to separate borrowers. One loan in the amount of $380
thousand is currently in escrow and is expected to close the first of May. It
currently has a LTV, based on the pending sale price, of 88%. The second loan
has a current carrying value of $298 thousand after the $145 thousand
write-down. The Bank is working with the borrower who has indicated a desire to
resolve the issues surrounding this credit.





Single
Family Residential- Spec





The
addition of $1.6 million is one loan with a current LTV based on the current
listing price of 90%. The listing price has been recently reduced to a level
that Management believes is more realistic. Two loans to one borrower were
written down by $703 thousand and $204 thousand, respectively.  As
these projects have been completed, these aggressive charge-off amounts are
reflective of current values and listing prices. The remaining charge-off amount
of $354 thousand is associated with a loan that has migrated to OREO. This
property is currently in escrow with a 30 day, no contingency closing. The Bank
expects this OREO to be off the books in the second quarter of 2009 with no
further write-down. This escrow was also a factor in the valuation of the other
two loans noted in this paragraph.  Additionally, more recent
indications obtained from prospective buyers of these distressed assets have
given Management a more refined picture of how the market expects to price
certain types of properties in the current environment. This has provided more
evidence to extrapolate fair values for similar types of
collateral.





Land





The new
items consist of two properties to two borrowers. One property in the carrying
amount of $123 thousand is well secured with a LTV of 17% and is located on the
coast within the Bank’s primary market area. The other property had an original
loan amount of $1.3 million that was written down to a value for which the Bank
currently has a commitment letter for purchase.





Since
March 31, 2009, the Bank was able to take possession of a property that had a
carrying value of $1.3 million and in the process of placing the property on the
market. There has been significant interest in this property that is located in
a prime coastal community.





At
quarter-end, non-accruing loan balances totaled $20.3 million, compared to $18.3
million at December 31, 2008.  As previously mentioned, in spite of
the year to date increase in non-performing assets, the Bank is encouraged to
see sale activity for $3 million in non-performing assets that is expected to
close in early May. There is also increased bona fide interest in properties as
reflective of the commitment to purchase letter that we have in hand for another
$1.0 million property.





Non-performing
assets increased to $23.2 million, or 2.66% of total assets at quarter end,
compared to $20.0 million, or 2.48% of total assets, at the end of the previous
quarter.  At March 31, 2009, the allowance for loan losses was
$10.4 million, or 1.51% of total gross loans, compared to $10.4 million, or
1.53% of total gross loans as of December 31, 2008.  Net charge-offs
during the quarter were $2.1 million.





The
Company recorded a $2.1 million provision for loan losses in the first quarter
of 2009, compared to a $6.0 million provision for loan losses in the previous
quarter and a $240 thousand provision for loan losses in the first quarter a
year ago.





At March
31, 2009, all non accruing balances were carried at their current fair
values.





Total
Cash and Cash Equivalents





Total
cash and due from banks was $60.6 million and $24.6 million at March 31, 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, higher deposit balances in conjunction with
funds the Company received from the U.S. Treasury under the CPP are reflected in
higher balances of federal funds sold.  As previously mentioned, the
Company is currently in the process of determining the most appropriate way to
deploy these funds.


- 44
-




Management’s
Discussion and Analysis


Investment
Securities and Other Earning Assets





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





The table
below summarizes the year to date change in the balances of other earning assets
as of March 31, 2009:





March
      31,
                                
                                
                                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
                                
                                
                                62,601
                                
                                
                                
                                50,762
                                
                                
                                
                                11,839
                                
                                
                                
                                23.32
                                %Federal
      funds sold
                                
                                
                                44,020
                                
                                
                                
                                6,650
                                
                                
                                
                                37,370
                                
                                
                                
                                561.95
                                %Interest
      bearing deposits other financial institutions
                                
                                
                                119
                                
                                
                                
                                119
                                
                                
                                
                                -
                                
                                
                                
                                0.00
                                %Total
      other earning assets
                                
                                $
                                112,568
                                
                                
                                $
                                62,654
                                
                                
                                $
                                49,914
                                
                                
                                
                                79.67
                                %





Federal
Home Loan Bank (“FHLB”) Stock





As a
member of the Federal Home Loan Bank of San Francisco, the Bank is required to
hold a specified amount of FHLB capital stock based on the level of borrowings
the Bank has obtained from the FHLB.  As such, the amount of FHLB
stock the Bank carries can vary from one period to another based on among other
things the current liquidity needs of the Bank.  At March 31, 2009,
the Bank held approximately $5.9 million in FHLB stock, an increase of
approximately $0.7 million from that reported at December 31, 2008.





Available
for Sale Investment Securities





At March
31, 2009 the balance of available for sale investment securities was
approximately $62.6 million or $11.8 million higher than that reported at
December 31, 2008.  The change in the balance of the portfolio can be
attributed in large part to purchases the Bank made in the aggregate amount
$20.5 million, sales and calls of securities in the aggregate amount of $5.4
million and principal pay downs totaling approximately $2.5
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 March 31, 2009 the securities portfolio had a net
unrealized loss, net of income taxes of approximately $1.7
million.  This represents an increase in the net unrealized loss
position of approximately $0.6 million when compared to that reported at
December 31, 2008.  The year to date decline in the fair value of the
securities portfolio can be attributed in large part to the decline in the value
of one particular CMO security subsequent to a downgrade.  The year to
date decline in value associated with this particular investment was
approximately $1.1 million as of March 31, 2009.  Management has
performed extensive reviews of this security, specifically with respect to the
Bank’s position and has determined that impairment was not other than temporary
as of March 31, 2009.





The Bank
had a total of nine whole loan CMO’s in the investment portfolio as of March 31,
2009 with a remaining principal balance of approximately $18.2
million.  This when compared to the $18.9 million in remaining
principal reported at December 31, 2008, represents a decline of approximately
$0.7 million.  These securities had a net unrealized loss of
approximately $3.1 million at March 31, 2009.  This represents an
increase in the net unrealized loss of approximately $1.0 million from that
reported at December 31, 2008.  The year to date increase in the net
unrealized loss position in these securities can be attributed a decline in the
value of one particular security mentioned in the preceding
paragraph.





The Bank
continues to perform extensive analyses on the underlying tranches associated
with all CMOs in the portfolio, including the particular investment mentioned in
the preceding paragraphs. By analyzing the tranche separate from the “mother”
security, the Bank has determined that there is no impairment and as such, is
not taking any action to write-down these securities. These investment
securities continue to demonstrate cash flows as expected and the credit support
component of these tranches has actually increased from the origination
date.   As of March 31, 2009, Management does not believe the
decline in market value of these securities is other than
temporary.


- 45
-




Management’s
Discussion and Analysis


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





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





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





Federal
Funds Sold





The year
to date increase in the balance of federal funds sold can be attributed in part
to higher deposit balances as well as $21.0 million in proceeds received from
the sale of preferred stock to the U.S. Treasury in connection with the
Company’s participation in the CPP.  As previously mentioned,
Management is currently in the process of determining the most appropriate way
to deploy these funds.  Additionally, 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.





Deposits
and Borrowed Funds





The
following table provides a summary for the year to date change in various
categories of deposit balances as of March 31, 2009:





Variance
      Exclusive ofMarch
      31,
                          
                          
                          December
      31,
                          
                          
                          Variance
                          
                          
                          Volatile
      Balances(dollars
      in thousands)
                          
                          2009
                          
                          
                          2008
                          
                          
                          dollar
                          
                          
                          percentage
                          
                          
                          dollar
                          
                          
                          percentageNon-interest
      bearing demand
                          
                          $
                          164,320
                          
                          
                          $
                          147,044
                          
                          
                          $
                          17,276
                          
                          
                          
                          11.75
                          %
                          
                          $
                          6,072
                          
                          
                          
                          4.13
                          %Interest
      bearing demand
                          
                          
                          64,289
                          
                          
                          
                          72,952
                          
                          
                          
                          (8,663
                          )
                          
                          
                          -11.87
                          %
                          
                          
                          1,158
                          
                          
                          
                          1.59
                          %Savings
                          
                          
                          23,056
                          
                          
                          
                          21,835
                          
                          
                          
                          1,221
                          
                          
                          
                          5.59
                          %
                          
                          
                          1,220
                          
                          
                          
                          5.59
                          %Money
      market
                          
                          
                          169,976
                          
                          
                          
                          173,199
                          
                          
                          
                          (3,223
                          )
                          
                          
                          -1.86
                          %
                          
                          
                          6,414
                          
                          
                          
                          3.70
                          %Time
      deposits
                          
                          
                          158,678
                          
                          
                          
                          139,872
                          
                          
                          
                          18,806
                          
                          
                          
                          13.45
                          %
                          
                          
                          18,806
                          
                          
                          
                          13.45
                          %Total
      retail deposits
                          
                          
                          580,319
                          
                          
                          
                          554,902
                          
                          
                          
                          25,417
                          
                          
                          
                          4.58
                          %
                          
                          
                          33,670
                          
                          
                          
                          6.07
                          %Brokered
      time deposits
                          
                          
                          38,500
                          
                          
                          
                          20,117
                          
                          
                          
                          18,383
                          
                          
                          
                          91.38
                          %
                          
                          
                          18,383
                          
                          
                          
                          91.38
                          %Brokered
      money market funds
                          
                          
                          46,002
                          
                          
                          
                          28,502
                          
                          
                          
                          17,500
                          
                          
                          
                          61.40
                          %
                          
                          
                          17,500
                          
                          
                          
                          61.40
                          %Total
      brokered deposits
                          
                          
                          84,502
                          
                          
                          
                          48,619
                          
                          
                          
                          35,883
                          
                          
                          
                          73.80
                          %
                          
                          
                          35,883
                          
                          
                          
                          73.80
                          %Total
      deposits
                          
                          $
                          664,821
                          
                          
                          $
                          603,521
                          
                          
                          $
                          61,300
                          
                          
                          
                          10.16
                          %
                          
                          $
                          69,553
                          
                          
                          
                          11.52
                          %





Deposits





The
current economic environment has presented many challenges to the Bank with
respect to the gathering of core deposits.  As conditions in the
credit markets and economic environment worsened throughout 2008 and into 2009,
many financial institutions in severe need of liquidity began to engage in
somewhat irrational deposit pricing, contributing to some run-off in core as
well as non-core promotional deposit balances.  Management chose not
to engage in this type of pricing and instead chose to seek funding from other
sources such as the FHLB and brokered deposits in an effort to not only maintain
our net interest margin, but to maintain a deposit base based on customer
relationship.


- 46
-




Management’s
Discussion and Analysis


During
the first quarter 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 certificate accounts with
balances less than $100 thousand) increase approximately $18.5 million during
the first quarter of 2009 from that reported at December 31, 2008, with
significant increases in non-interest bearing demand 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 March 31, 2009, brokered deposit balances totaled
approximately $84.5 million, an increase of approximately $35.9 million from
that reported at December 31, 2008.  Year to date increases in
brokered funds can be attributed in large part to the funding of securities the
Bank purchased during the first quarter.





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 the balance in federal funds sold.  At March 31,
2009, the aggregate balance of deposits the Bank considers to be volatile was
approximately $53.3 million or $8.3 million lower that that reported at December
31, 2008.





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





Percent
      of
                          
                          
                          
                          
                          
                          Percent
      ofMarch
      31,
                          
                          
                          Total
                          
                          
                          December
      31,
                          
                          
                          Total
                          
                          
                          Dollar(dollars
      in thousands)
                          
                          2009
                          
                          
                          Deposits
                          
                          
                          2008
                          
                          
                          Deposits
                          
                          
                          VarianceNon-interest
      bearing demand
                          
                          $
                          22,397
                          
                          
                          
                          3.4
                          %
                          
                          $
                          11,193
                          
                          
                          
                          1.9
                          %
                          
                          $
                          11,204Interest
      bearing demand
                          
                          
                          11,874
                          
                          
                          
                          1.8
                          %
                          
                          
                          21,695
                          
                          
                          
                          3.6
                          %
                          
                          
                          (9,821
                          )Savings
      deposits
                          
                          
                          197
                          
                          
                          
                          0.0
                          %
                          
                          
                          196
                          
                          
                          
                          0.0
                          %
                          
                          
                          1Money
      market deposits
                          
                          
                          18,845
                          
                          
                          
                          2.8
                          %
                          
                          
                          28,482
                          
                          
                          
                          4.7
                          %
                          
                          
                          (9,637
                          )Total
      volatile deposits
                          
                          $
                          53,313
                          
                          
                          
                          8.0
                          %
                          
                          $
                          61,566
                          
                          
                          
                          10.2
                          %
                          
                          $
                          (8,253
                          )





The
following provides a summary of the notable relationships that comprise the
majority of the volatile balance represented in the table above as of March 31,
2009:





·
            Non-Interest
      Bearing Demand





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 begun to increase.  Management and the Board
of Directors are aware that as conditions in the market change these
relationships will be impacted.





·
            Interest
      Bearing Demand





The
majority of balances within this category are representative of one relationship
which is considered public funds.  The year to date decline within
this category can be attributed to one relationship.





·
            Money
      Market





At March
31, 2009, the majority of volatile balances within this category were held by
four depositors with aggregate balances of approximately $12.1
million.  Balances within this category declined approximately $9.6
million from that reported at December 31, 2008.  Management has been
aware that balances associated with one particular relationship would experience
ongoing declines due to the customer’s intention to place funds in other
investment vehicles and to make tax payments.


- 47
-


Management’s
Discussion and Analysis


Borrowed
Funds





The Bank
has a variety of sources from which it may obtain secondary
funding.  These sources include, among others, the FHLB, 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 March
31, 2009, borrowings obtained from the FHLB comprised the majority of borrowed
funds.  The following table provides a summary of FHLB borrowings the
Bank had as of March 31, 2009:





(dollars
in thousands)





Amount
            
            
            Interest
            
            MaturityBorrowed
            
            
            Rate
            
            Variable/Fixed
            
            Date$
            60,000
            
            
            
            0.32
            %
            Variable
            
            Open25,000
            
            
            
            0.82
            %
            Fixed
            
            6/22/0910,000
            
            
            
            2.89
            %
            Fixed
            
            9/16/10$
            95,000
            
            
            
            0.72
            %




As
evidenced in the table above, the balance of FHLB borrowing as of March 31, 2009
was $95.0 million.  This represents a decline of approximately $14.0
million from the balance reported at December 31, 2008.  The year to
date decline can be attributed to higher deposit balances during the first
quarter of 2009.





In the
fourth quarter of 2007, the Company renewed a promissory note with Pacific Coast
Bankers Bank (“PCBB”) for a revolving line of credit in the amount of $3.5
million.  At March 31, 2009, the Company had no balance outstanding on
this note. The Company pledged 646,598 shares (51%) of the Bank’s stock as
collateral for the loan. The note is revolving in nature for the first two
years. The terms of the note call for quarterly interest only payments for the
first two years with subsequent principal and interest payments for eight years
on a fully amortized basis.  At March 31, 2009 the interest rate on
the note was 3.25% and is variable, moving with prime. Under the terms of the
agreement, the Company will not incur any additional debt over $2.0 million
exclusive of inter-company debt and existing debt without the prior written
consent of PCBB.  In addition, the Bank must be “well” capitalized on
an on-going basis as defined by bank regulators.





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
will expire in September 2009.





Capital





At March
31, 2009, the balance of stockholders’ equity was approximately $91.6
million.  This, when compared to the $70.0 million at December 31,
2008, represents an increase of approximately $21.6 million. The year to date
change in capital is due in large part to $21.0 million in senior preferred
stock the Company issued to the U.S. Treasury as part of its participation in
the CPP.   Additionally, the year to date change is also
attributed to net income of $1.1 million, the impact of year-to-date share-based
compensation expense in the amount of $90 thousand and a decline in the balance
of accumulated other comprehensive income in the amount of $0.6
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).


- 48
-




Management’s
Discussion and Analysis


For
additional information regarding the Company’s Senior Preferred Stock and its
participation in the CPP, see Note 8 of the consolidated financial statements
filed on this Form 10-Q.





Dividends





The
following table provides a summary of dividends the Company has paid 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
                              
                              05/18/07Cash
      dividend
                              
                              $
                              0.08
                              
                              01/19/07
                              
                              02/02/07
                              
                              02/16/07





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 quarter 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 March
31, 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 1.71% variable rate and 6.888% fixed,
respectively.


- 49
-


Management’s
Discussion and Analysis


The
following table provides a summary of the securities the Company has issued to
Trusts II and III as of March 31, 2009:


Amount
                                            
                                            
                                            Current
                                            
                                            Issue
                                            
                                            Scheduled
                                            
                                            Call(dollars
      in thousands)
                                            
                                            Issued
                                            
                                            
                                            Rate
                                            
                                            Date
                                            
                                            Maturity
                                            
                                            Date
                                            
                                            Rate
      TypeHeritage
      Oaks Capital Trust II
                                            
                                            $
                                            8,248
                                            
                                            
                                            
                                            3.155
                                            %
                                            27-Oct-06
                                            
                                            Aug-37
                                            
                                            Nov-11
                                            
                                            Variable
      3-month LIBOR + 1.71%Heritage
      Oaks Capital Trust III
                                            
                                            
                                            5,155
                                            
                                            
                                            
                                            6.888
                                            %
                                            20-Sep-07
                                            
                                            Sep-37
                                            
                                            Dec-12
                                            
                                            5-year
      Fixed SWAP + 2.00%Total
      Issued
                                            
                                            $
                                            13,403
                                            
                                            
                                            
                                            4.59
                                            %





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





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





At March
31, 2009, the Company had sufficient cash to service the $13.4 million in junior
subordinated debenture interest payments for approximately 20 years without
dividends from subsidiaries. The Bank’s capacity to provide cash to the Company,
while remaining “well-capitalized”, was approximately $11.7 million at March 31,
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 March 31, 2009 and 2008:





Regulatory
      Standard
                
                
                March
      31, 2009
                
                
                March
      31, 2008Adequately
                
                
                Well
                
                
                Heritage
      Oaks
                
                
                Heritage
      OaksRatio
                
                Capitalized
                
                
                Capitalized
                
                
                Bancorp
                
                
                Bank
                
                
                Bancorp
                
                
                BankLeverage
      ratio
                
                
                4.00
                %
                
                
                5.00
                %
                
                
                11.35
                %
                
                
                9.75
                %
                
                
                9.30
                %
                
                
                8.82
                %Tier
      I capital to risk weighted assets
                
                
                4.00
                %
                
                
                6.00
                %
                
                
                11.92
                %
                
                
                10.24
                %
                
                
                9.82
                %
                
                
                9.28
                %Total
      risk based capital to risk weighted assets
                
                
                8.00
                %
                
                
                10.00
                %
                
                
                13.17
                %
                
                
                11.49
                %
                
                
                10.76
                %
                
                
                10.22
                %




- 50
-




Management’s
Discussion and Analysis


Regulatory
capital ratios as of March 31, 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.  Following the issuance, the holding company down-streamed $10.0
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 March 31, 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 March 31, 2009, these credit lines totaled $20.0 million
and the Bank had no borrowings against those lines.  As previously
mentioned the Bank is a member of the FHLB and has collateralized borrowing
capacities remaining of $98.2 million at March 31, 2009.





The Bank
manages liquidity by maintaining a majority of the investment portfolio in
federal funds sold and other liquid investments.  The majority of
these investments include obligations of state and political subdivisions
(municipal bonds) and mortgage related securities that provide a relatively
steady stream of cash flows.  As of March 31, 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 11.50% at March 31, 2009 compared to 6.79% at December 31,
2008.   At March 31, 2009, the Bank was within its internal
guideline for liquidity.  The ratio of net loans to deposits (“LTD”),
another key liquidity ratio, was 102.2% at March 31, 2009 compared to 110.7% at
December 31, 2008 both of which are and were within the Bank’s policy
guidelines.  While the Bank still provides the majority of loan
funding with core deposits, due to the highly competitive nature of deposit
gathering and given the current economic environment, the Bank has found it
necessary to rely on borrowed funds from time to time.  With the
banking industry’s common use of alternative funding sources, i.e. FHLB
borrowing, the Bank implemented a tracking ratio of Loan-to-Funding (“LTF”) in
2006.  This ratio is calculated by dividing gross loans by the sum of
total deposits and alternative funding sources both available and
used.  At March 31, 2009, the LTF ratio was 80.6%, compared to 87.2%
at December 31, 2008.  The Bank’s key focus has been and remains to
increase core deposits and minimize alternative funding sources.





The
following table provides a summary of the remaining borrowing capacity the
Company has with various secondary liquidity sources as of March 31,
2009:





(dollars
      in thousands)
                        
                        March
      31, 2009Federal
      Home Loan Bank remaining borrowing capacity
                        
                        $
                        98,200Correspondent
      bank credit arrangements
                        
                        
                        20,000Brokered
      funds availability
                        
                        
                        60,578Revolving
      line of credit - Holding Company
                        
                        
                        3,500Total
      available secondary liquidity source
                        
                        $
                        182,278





The
following table provides additional information regarding the Company’s
liquidity as of March 31, 2009:





(dollars
      in thousands)
                        
                        March
      31, 2009Total
      cash and due from
                        
                        $
                        16,553Federal
      funds sold
                        
                        
                        44,020Unencumbered
      available for sale investments
                        
                        
                        11,868Loans
      held for sale
                        
                        
                        13,806Total
      available secondary funding
                        
                        
                        182,278Total
      liquid assets and available funding
                        
                        $
                        268,525Total
      deposits and other borrowing
                        
                        $
                        759,821Ratio
      of liquid assets and available funding to total deposits and other
      borrowings
                        
                        
                        35.3
                        %




- 51
-




Management’s
Discussion and Analysis


During
the fourth quarter of 2008, a credit line previously established with a
correspondent bank in the amount of $20.0 million was temporarily
suspended.  Due to overall instability in the financial markets this
particular correspondent bank determined it necessary to re-assess all lines of
credit.  Management is currently in the process of working with this
correspondent bank in an effort to re-establish the line.  However if
the line cannot be re-established, the Bank has recently been solicited by other
correspondent banks to provide a similar credit arrangement.





The Bank
has a policy that permits the purchase of brokered funds in an amount not to
exceed 20% of total deposits.  As previously mentioned, Management has
purchased brokered funds in an effort to rely less on FHLB borrowings and
maintain an appropriate mix of secondary funding.  At March 31, 2009,
the balance of brokered funds was approximately $84.5 million or $35.9 million
higher than that reported at December 31, 2008.  The majority of the
year to date increase in brokered funds can be attributed in part to securities
the Bank purchased in the first quarter of 2009.





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 of 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 of 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 in “Capital,” the Company issued
the full and unconditional payment guarantee of certain accrued
distributions.


- 52
-


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.  Management believes that it can continue to
manage the short-term effect of interest rate changes under various interest
rate scenarios.





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




The
hypothetical impacts of sudden interest rate movements applied to the Company’s
asset and liability balances are modeled monthly. The results of these models
indicate how much of the Company’s net interest income is “at risk” from various
rate changes over a one year horizon. This exercise is valuable in identifying
risk exposures. Management believes the results for the Company’s March 31, 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 March 31, 2009, if interest rates were to
change in the amounts set forth:





Rate
      Shock Scenarios(dollars
      in thousands)
                  
                  
                  -200bp
                  
                  
                  
                  -100bp
                  
                  
                  Base
                  
                  
                  
                  +100bp
                  
                  
                  
                  +200bpNet
      interest income (NII)
                  
                  $
                  39,900
                  
                  
                  $
                  41,136
                  
                  
                  $
                  42,130
                  
                  
                  $
                  43,107
                  
                  
                  $
                  44,246$
      Change from base
                  
                  $
                  (2,230
                  )
                  
                  $
                  (994
                  )
                  
                  $
                  -
                  
                  
                  $
                  977
                  
                  
                  $
                  2,116%
      Change from base
                  
                  
                  -5.29
                  %
                  
                  
                  -2.36
                  %
                  
                  
                  0.00
                  %
                  
                  
                  2.32
                  %
                  
                  
                  5.02
                  %




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.


- 53
-





The
following tables show Management’s estimates of how the loan portfolio is broken
out between variable-daily, variable at various time lines, fixed rate loans and
estimates of re-pricing opportunities for the entire loan portfolio at March 31,
2009:





(dollars
      in thousands)Percent
      ofRate
      Type
                      
                      Balance
                      
                      
                      TotalVariable
      - daily
                      
                      
                      299,333
                      
                      
                      
                      43.3
                      %Variable
      other than daily
                      
                      
                      241,116
                      
                      
                      
                      34.9
                      %Fixed
      rate
                      
                      
                      151,192
                      
                      
                      
                      21.8
                      %Total
      gross loans
                      
                      $
                      691,641
                      
                      
                      
                      100.0
                      %





The table
above identifies approximately 43.3% of the loan portfolio that will re-price
immediately in a changing rate environment.  At March 31, 2009,
approximately $540.4 million or 78.2% of the Bank’s loan portfolio is considered
variable.





(dollars
      in thousands)Percent
      ofRe-Pricing
                      
                      Balance
                      
                      
                      Total<
      1 Year
                      
                      $
                      402,829
                      
                      
                      
                      58.2
                      %1-3
      Years
                      
                      
                      169,406
                      
                      
                      
                      24.5
                      %3-5
      Years
                      
                      
                      70,249
                      
                      
                      
                      10.2
                      %>
      5 Years
                      
                      
                      49,157
                      
                      
                      
                      7.1
                      %Total
      gross loans
                      
                      $
                      691,641
                      
                      
                      
                      100.0
                      %





The
following table provides a summary of the loans the Bank can expect to see come
off their floors if the prime rate were to increase by the amounts identified
below as of March 31, 2009:





Move
      in Prime Rate (bps)(dollars
      in thousands)
                        
                        
                        +200
                        
                        
                        
                        +250
                        
                        
                        
                        +300
                        
                        
                        
                        +350Variable
      daily
                        
                        $
                        4,342
                        
                        
                        $
                        18,856
                        
                        
                        $
                        46,923
                        
                        
                        $
                        103,693Variable
      other than daily
                        
                        
                        2,365
                        
                        
                        
                        3,036
                        
                        
                        
                        39,556
                        
                        
                        
                        93,752Cumulative
      total variable at floor
                        
                        $
                        6,707
                        
                        
                        $
                        21,892
                        
                        
                        $
                        86,479
                        
                        
                        $
                        197,445





Given the
significant year over year decline in the over night Fed Funds 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 March 31, 2009 that has materially affected, or is reasonably
likely to materially affect, the Company’s internal controls over financial
reporting.


- 54
-


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





Part
II.  Other Information





Item
1.  Legal Proceedings





The
Company is not a party to any material legal proceeding.





Item
1A.  Risk Factors





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





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





Unregistered
Sale of Equity Securities





On March
20, 2009, The Company issued and sold 21,000 shares of its Senior Preferred
Stock with a stated value of $1,000 per share and a warrant to purchase 611,650
shares of the Company’s common stock at an exercise price of $5.15 per share to
the U.S. Treasury as part of its participation in the TARP Capital Purchase
Program for an aggregate purchase price of $21.0 million in cash.  The
issuance and sale of these securities was a private placement exempt from
registration pursuant to Section 4(2) of the Securities Act of
1933.





The
preferred stock will carry a coupon of 5% per annum for the first five years and
9% per annum thereafter.  The preferred stock issued to the U.S.
Treasury will be non-voting, cumulative, perpetual and may be redeemed at 100%
of their stated value three years following the date of issue only if
(i) the Company has raised aggregate gross proceeds in one or more
Qualified Equity Offerings.  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 shares of Common Stock underlying the warrants held by the
U.S. Treasury will be reduced by one-half of the shares of Common Stock
originally covered by the warrant.  For the purposes of the foregoing,
“Qualified Equity Offering” is defined as the sale and issuance for cash by the
Company to persons other than the Company or any Company subsidiary after the
closing date of shares of Preferred Stock, Common Stock or any combination of
such stock, that, in each case, qualify as and may be included in Tier I capital
of the Company at the time of issuance under the applicable risk-based capital
guidelines of the Company’s federal banking agency.





The
Purchase Agreement pursuant to which the Preferred Shares and the warrant were
sold, contains limitations on the payment of dividends on the Common Stock and
on the Company’s ability to repurchase its Common Stock, and subjects the
Company to certain of the executive compensation limitations included in the
EESA.  As a condition to the closing of the transaction, each of the
Company’s Senior Executive Officers (as defined in the Purchase Agreement) (the
“Senior Executive Officers”), (i) executed a waiver (the “Waiver”)
voluntarily waiving any claim against the Treasury or the Company for any
changes to such Senior Executive Officer’s compensation or benefits that are
required to comply with the regulation issued by the Treasury under the TARP CPP
as published in the Federal Register on October 20, 2008 and acknowledging
that the regulation may require modification of the compensation, bonus,
incentive and other benefit plans, arrangements and policies and agreements
(including so-called “golden parachute” agreements) (collectively, “Benefit
Plans”) as they relate to the period the Treasury holds any equity or debt
securities of the Company acquired through the TARP CPP; and (ii) entered
into a letter agreement (the “Letter Agreement”) with the Company amending the
Benefit Plans with respect to such Senior Executive Officer as may be necessary,
during the period that the Treasury owns any debt or equity securities of the
Company acquired pursuant to the Purchase Agreement or the Warrant, as necessary
to comply with Section 111(b) of the EESA.




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Copies of
the Purchase Agreement, the warrant, the form of Waiver executed by the Senior
Executive Officers and the form of Letter Agreement executed by the Senior
Executive Officers were included as exhibits to a Form 8-K filed by the Company
on March 23, 2009. The foregoing summary of certain provisions of these
documents is brief and readers are urged to read the 8-K previously filed and
the exhibits to that 8-K for complete terms of the transaction.





Purchases
of Equity Securities





None.





Item
3.  Defaults upon Senior Securities





None.





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





During
the first quarter of 2009, the Company received shareholder approval to amend
its articles of incorporation to authorize a class of 5,000,000 shares of
preferred stock, no par value.  Prior to shareholder approval, the
Articles of Incorporation only included the authorization to issue 20,000,000
shares of common stock.  The amendment gives the Company’s Board of
Directors the authority to determine the terms of one or more series of
preferred stock, including the preferences, rights, and limitations of each
series.  This amendment allowed the Company to issue $21.0 million
Senior Preferred Stock to the U.S. Treasury as part of its participation in the
CPP.





The
following proposals were adopted by the margins indicated in the tables
below:





1.  Approval
to amend the Company’s Articles of Incorporation to add a class of 5,000,000
shares of authorized preferred stock.





Percentage
      ofVoter
      Type
                      
                      Shares
      Voted
                      
                      
                      Proxy
      SharesIndividuals
                      
                      
                      2,606,384
                      
                      
                      
                      33.62
                      %Brokers
                      
                      
                      2,385,971
                      
                      
                      
                      30.77
                      %Special
                      
                      
                      1,867
                      
                      
                      
                      0.03
                      %Total
      shares voted
                      
                      
                      4,994,222
                      
                      
                      
                      64.42
                      %





Reference
is also made to the Company’s Definitive Proxy Statement filed with the
Commission on February 5, 2009 on Form 14A for additional information regarding
the matter disclosed above.





Item
5.  Other Information





Not
applicable.


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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




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Signatures





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





Heritage
      Oaks BancorpDate:
      May 8, 2009/s/ Lawrence P. WardLawrence
      P. WardPresidentChief
      Executive Officer/s/ Margaret A. TorresMargaret
      A. TorresExecutive
      Vice PresidentChief
      Financial Officer(Principal
      Financial and Accounting Officer)


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